Friday, July 8, 2011

Buffett: "Look-Through" Earnings Revisited - Berkshire Shareholder Letter Highlights (BRKa, AXP, KO, MTB, WPO, WFC)

One of the concepts that Warren Buffett has emphasized in a number of the annual shareholder letters over the years is the importance of "look-through" earnings.

From the 1999 Berkshire Hathaway (BRKa) shareholder letter:

Reported earnings are an inadequate measure of economic progress at Berkshire, in part because the numbers shown in the table presented earlier include only the dividends we receive from investees -- though these dividends typically represent only a small fraction of the earnings attributable to our ownership. Not that we mind this division of money, since on balance we regard the undistributed earnings of investees as more valuable to us than the portion paid out. The reason for our thinking is simple: Our investees often have the opportunity to reinvest earnings at high rates of return. So why should we want them paid out?

To depict something closer to economic reality at Berkshire than reported earnings, though, we employ the concept of "look-through" earnings. As we calculate these, they consist of: (1) the operating earnings reported in the previous section, plus; (2) our share of the retained operating earnings of major investees that, under GAAP accounting, are not reflected in our profits, less; (3) an allowance for the tax that would be paid by Berkshire if these retained earnings of investees had instead been distributed to us. When tabulating "operating earnings" here, we exclude purchase-accounting adjustments as well as capital gains and other major non-recurring items.

The following table sets forth our 1999 look-through earnings, though I warn you that the figures can be no more than approximate, since they are based on a number of judgment calls.
---
Berkshire's ApproximateBerkshire's Share of Undistributed
Berkshire's Major InvesteesOwnership at Yearend(1)Operating Earnings (in millions)(2)
American Express (AXP)
11.3%
$228
Coca-Cola (KO)
8.1%
144
Freddie Mac ....
8.6%
127
The Gillette Company ....
9.0%
53
M&T Bank (MTB)
6.5%
17
Washington Post (WPO)
18.3%
30
Wells Fargo (WFC)
3.6%
108
Berkshire's share of undistributed earnings of major investees
707
Hypothetical tax on these undistributed investee earnings(3)
(99)
Reported operating earnings of Berkshire
1,318
     Total look-through earnings of Berkshire
$ 1,926
=====
     (1) Does not include shares allocable to minority interests
     (2) Calculated on average ownership for the year
     (3) The tax rate used is 14%, which is the rate Berkshire pays on the dividends it receives 

Naturally, most portfolios do not have operating earnings so the undistributed earnings minus hypothetical taxes is the "look-through" earnings. The calculation is a worthwhile exercise. I gauge the progress of a portfolio primarily based upon the growth in those "look-through" earnings over time not the change in stock prices.

This helps erase the noise that is created by market prices. If the "look-through" earnings grow at a satisfactory rate, while the competitive advantages of the businesses remain in tact (or ideally become larger over time), then returns will work out just fine in the long run.

Well, at least if shares were bought at fair prices in the first place.

Adam

Long positions in BRKb, AXP, KO, and WFC

Related post: Buffett on "Look-Through" Earnings

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