Look-Through Earnings Meaning and How They Work

Look-Through Earnings Meaning and How They Work

Look-Through Earnings: Meaning and How They Work

What Are Look-Through Earnings?

Look-through earnings take the current period earnings of a company (reported quarterly or annually) and add all expected future earnings sources. They are not a quantity, but rather based on the idea that a firm’s value is determined by how retained earnings are invested to generate more earnings.

Warren Buffett coined the term "look-through earnings" to overcome accounting limitations in determining a company’s intrinsic value. He focuses on a firm’s long-term earnings-generation capacity rather than annual reported numbers.

Key Takeaways

  • Warren Buffett coined the concept of look-through earnings to address accounting limitations.
  • Look-through earnings include earnings paid to investors and funds reinvested by a company.
  • Buffett believes look-through earnings provide a more realistic depiction of a firm’s value to investors.
  • Investors may seek companies with higher retained earning growth for tax strategies and future dividends.

Understanding Look-Through Earnings

Warren Buffett explained look-through earnings in his booklet "An Owner’s Manual," which outlined Berkshire Hathaway’s economic principles. Buffett emphasized the inclusion of undistributed earnings from major investees to offset accounting shortcomings.

Buffett regards look-through earnings as a realistic portrayal of Berkshire’s annual gain from operations, despite the omission of these numbers in conventional accounting.

READ MORE  Universal Healthcare Coverage What it is How it Works Types

How to Calculate Look-Through Earnings

To calculate look-through earnings, add dividend income and share of retained earnings, then subtract taxes on dividends.

Look-Through Earnings = (Dividends Received + Retained Earnings) – Tax on Dividends

Start by determining dividends paid by the company you own stock in. Next, calculate the portion of retained earnings applicable to your holdings. Finally, determine the tax rate on dividend income.

Look-through earnings provide a comprehensive view of financial benefits and tax implications, helping investors assess the true economic impact of their investments.

Metrics to Evaluate Look-Through Earnings

Evaluating look-through earnings is essential for investors. Consider these metrics:

  1. Look-Through Earnings Growth Rate. Tracks the growth rate of look-through earnings over time.
  2. Look-Through Earnings Yield. Measures the look-through earnings yield by dividing look-through earnings by market value.
  3. Dividend Yield. Determines the dividend yield by dividing annual dividend income by market value.
  4. Total Return. Considers both capital appreciation and income to gauge investment performance.

Some investors may seek investments with low dividends but high retained earning growth for future growth potential and lower tax brackets.

Berkshire Hathaway and Look-Through Earnings

Buffett believes Berkshire Hathaway’s intrinsic value has grown in line with look-through earnings and applies this principle to any company. Profits, whether distributed or reinvested, benefit shareholders. Ignoring retained earnings undervalues the stock.

Buffett emphasizes long-term evaluation of stocks and highlights the growth of look-through earnings and Berkshire’s stock price over the years.

Example of Look-Through Earnings

Let’s calculate look-through earnings using a fictional company, Company XYZ. Assume you own 10,000 shares (10% ownership stake) and the company reported:

  • Dividends Paid: $50,000
  • Retained Earnings: $200,000
  • Tax Rate on Dividends: 20%
READ MORE  Uniform Policy Provisions Health Insurance

Dividends received would be $5,000 based on your ownership stake. Proportional retained earnings for your holdings would be $20,000. Subtracting the applicable tax of $1,000, your final look-through earnings are $24,000.

Look-through earnings capture the value of retained earnings in addition to gross dividends received.

How Do You Calculate Look-Through Earnings?

Look-through earnings consider dividends and retained earnings per share. It accounts for the portion of after-tax earnings retained and reinvested into a company’s growth.

How Can an Investor Use Look-Through Earnings?

An investor seeking capital appreciation should focus on stocks with high look-through earnings. Shifting investments for higher earnings potential is a common strategy.

What Is Look-Through Analysis?

Look-through analysis evaluates portfolio holdings to assess risks, diversification, and cash flows. It helps identify similarities in cash flow sources and analyze ESG portfolios.

The Bottom Line

Look-through earnings consider dividends, retained earnings, and taxes, providing a more comprehensive view of an investment’s true value. Companies with retained earnings may have growth potential and future dividend increases.

Leave a Reply

Your email address will not be published. Required fields are marked *