Monday, May 23, 2011

Buffett on "Look-Through" Earnings: Berkshire Shareholder Letter Highlights

Warren Buffett wrote the following in the 1989 Berkshire Hathaway (BRKashareholder letter:

In addition to our reported earnings, we also benefit from significant earnings of investees that standard accounting rules do not permit us to report...we list five major investees from which we received dividends in 1989 of about $45 million, after taxes. However, our share of the retained earnings of these investees totaled about $212 million last year, not counting large capital gains realized by GEICO and Coca-Cola. If this $212 million had been distributed to us, our own operating earnings, after the payment of additional taxes, would have been close to $500 million rather than the $300 million shown in the table.

The question you must decide is whether these undistributed earnings are as valuable to us as those we report. We believe they are - and even think they may be more valuable. The reason for this a-bird-in-the-bush-may-be-worth-two-in-the-hand conclusion is that earnings retained by these investees will be deployed by talented, owner-oriented managers who sometimes have better uses for these funds in their own businesses than we would have in ours. I would not make such a generous assessment of most managements, but it is appropriate in these cases.

In our view, Berkshire's fundamental earning power is best measured by a "look-through" approach, in which we append our share of the operating earnings retained by our investees to our own reported operating earnings, excluding capital gains in both instances.

So forty percent of Berkshire's economic earnings came from "look-through" earnings back in 1989.

This year it will be a much lower percent yet still certainly material.

Partial ownership via shares held in companies like Coca-Cola (KO), Wells Fargo (WFC), American Express (AXP), Procter & Gamble (PG), Kraft (KFT), Johnson & Johnson (JNJ) are now the main drivers of "look-through" earnings for Berkshire Hathaway.

From the Berkshire Hathaway owners manual:

Accounting consequences do not influence our operating or capital-allocation decisions. When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles than to purchase $1 of earnings that is reportable. This is precisely the choice that often faces us since entire businesses (whose earnings will be fully reportable) frequently sell for double the pro-rata price of small portions (whose earnings will be largely unreportable). In aggregate and over time, we expect the unreported earnings to be fully reflected in our intrinsic business value through capital gains.

We have found over time that the undistributed earnings of our investees, in aggregate, have been fully as beneficial to Berkshire as if they had been distributed to us (and therefore had been included in the earnings we officially report). This pleasant result has occurred because most of our investees are engaged in truly outstanding businesses that can often employ incremental capital to great advantage, either by putting it to work in their businesses or by repurchasing their shares. Obviously, every capital decision that our investees have made has not benefitted us as shareholders, but overall we have garnered far more than a dollar of value for each dollar they have retained. We consequently regard look-through earnings as realistically portraying our yearly gain from operations.

These days, excluding "look-through" earnings, Berkshire's after tax earning power is in the $12-13 billion range compared to the $ 300 million back in 1989.

That $12-13 billion of earnings, while fluctuating quite a bit from year to year, will continue to grow at a nice clip though not nearly as fast as it has in the past 20 years. Yet it still materially understates Berkshire's economic earnings (though the understatement is a lower percentage than in 1989).

For quite some time now Berkshire's growth in earnings has been driven by an emphasis on buying whole businesses instead of partial ownership via common stocks. So naturally Berkshire's operating businesses now play a more substantial role in the earnings picture (and, of course, intrinsic business value) compared to 1989.

Having said that Berkshire's current ~$ 60 billion equity portfolio, the driver of "look-through" earnings these days, still easily add another 15-20% to the $ $ 12-13 billion in annual earnings.

As Buffett explains above, the extra 15-20% will not show up in the reported GAAP results but economically they are just as significant.

The fact that they are treated differently is more a reflection of the inherent limitations of accounting. Those limitations in the accounting discipline do not make them any less real to an investor in an economic sense.

Adam

Long all stocks mentioned
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