Look-Through Earnings: Meaning and How They Work

What Are Look-Through Earnings?

Look-through earnings take the current period earnings of a company (as reported in a quarterly or annual report) and add to that figure all sources of earnings expected in the long run. Look-through earnings are not necessarily a quantity; instead, look-through earnings are based on the concept that a firm's value is ultimately determined by how retained earnings are invested in future years by the firm to produce more earnings.

The term "look-through earnings" is attributed to famed investor Warren Buffett, who prefers this concept to overcome some limitations of accounting rules in determining the intrinsic values of companies. Buffett is more interested in the long-term earnings-generation capacity of a firm and less so in the annual reported numbers in its financial statements.

Understanding Look-Through Earnings

Warren Buffett explained his concept of look-through earnings in his booklet "An Owner's Manual," which was originally distributed to Berkshire Hathaway Inc. Class A and Class B shareholders in 1996 and updated in 1999. The booklet aimed to explain Berkshire's broad economic principles of operation. In the booklet, Buffett laid out 13 "owner-related business principles."

Buffett explains the look-through earnings concept clearly in the following passage, which appears as "Principle No. 6."

"We attempt to offset the shortcomings of conventional accounting by regularly reporting 'look-through' earnings (though, for special and nonrecurring reasons, we occasionally omit them). The look-through numbers include Berkshire's own reported operating earnings ... plus Berkshire's share of undistributed earnings of our major investees—amounts that are not included in Berkshire's figures under conventional accounting ...

...We have found over time that 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 benefited 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."

How to Calculate Look-Through Earnings

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

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

Start by determining the dividends paid by the company whose stock you own. Dividends are typically paid periodically, such as quarterly or annually, and represent a portion of the company's profits distributed to its shareholders. This is usually straightforward, as this is the amount of cash return an investor has received.

Next, determine the portion of retained earnings applicable to your holdings. Retained earnings are the portion of a company's profits that are not distributed as dividends but are reinvested back into the business. These earnings contribute to the company's growth, yet these theoretically hold future economic benefit to the investor and its value should be captured. You may need to apply your ownership proportion to the outstanding equity.

Last, because dividends may be taxable as they may be income that are distributed, determine the applicable tax rate on dividend income. This is typically the tax rate for qualified dividends which may be different from your regular income tax rate. Note that dividends may be earned in a tax-advantaged account and not subject to taxes

In essence, look-through earnings provide a more comprehensive view of the financial benefits and tax implications of an investment in a stock. By considering both dividends received and a share of retained earnings, investors can better assess the true economic impact of their investments.

Metrics to Evaluate Look-Through Earnings

Evaluating look-through earnings is essential for investors to assess the true economic impact of their investments. Here are some metrics and considerations to evaluate these earnings.

1. Look-Through Earnings Growth Rate. This calculation tracks the growth rate of your look-through earnings over time. A consistent increase in look-through earnings can indicate a healthy and growing investment.
2. Look-Through Earnings Yield. This calculation measures the look-through earnings yield by dividing the look-through earnings by the market value of your investment. This metric is similar to the price-to-earnings (P/E) ratio but takes into account both dividends and retained earnings.
3. Dividend Yield. This formula determines the dividend yield which is the annual dividend income divided by the market value of your investment. It helps assess the cash flow generated by your investment through dividends.
4. Total Return. This basic calculation considers the total return on your investment which includes both capital appreciation (changes in stock price) and income (dividends and retained earnings). It provides a holistic view of how your investment is performing, and you can compare this value with your look-through earnings to gauge how much value is being inherently held in retained earnings.

Berkshire Hathaway and Look-Through Earnings

Buffett believes that the intrinsic value of Berkshire Hathaway Inc. has grown at approximately the same rate as its look-through earnings in the past and will continue to do so in the future. Moreover, he believes this principle applies to any company. The idea is that all corporate profits benefit shareholders, whether they are paid out as cash dividends or invested back into the company. If an investor were to only regard the dividends he received from his shares as his return, he would ignore most of the funds—and the stock value—that was accruing to his benefit.

The look-through earnings concept, Buffett has said, forces investors to evaluate stocks for the long term. “We continue to make more money when snoring than when active,” he explained to investors in 1996. “Our look-through earnings have grown at a good clip over the years, and our stock price has risen correspondingly. Had those gains in earnings not materialized, there would have been little increase in Berkshire’s value.”

Example of Look-Through Earnings

Let's walk through an example of calculating look-through earnings. In this example, we'll use a fictional company, Company XYZ, in which you own stock. You own 10,000 shares of Company XYZ, which has a total of 100,000 outstanding shares, giving you a 10% ownership stake in the company. Company XYZ reported the following financial information for the year:

• Dividends Paid: $50,000
• Retained Earnings: $200,000
• Tax Rate on Dividends: 20%

First, calculate the dividends you received. Assuming the $50,000 of dividends awarded was issued to all investors, your 10% stake would have warranted $5,000 of dividends. Second, calculate the proportional retained operating earnings the company kept instead of issuing a dividend. In this example, your 10% ownership relates to a share of $20,000 ($200,000 * 10%). Let's also assume the 20% tax rate on dividends means you'll pay $1,000 on the $5,000 of dividends you receive.

In this example, your final look through will be ($5,000 + $20,000 - $1,000) $24,000. Even though the investor only received gross dividends of $5,000, the investor has substantial value in the capital the company retained. In theory, the company will used retained earnings to grow, thus being able to issue larger dividends to the investor in the future.

The Bottom Line

Look-through earnings consider dividends, retained earnings, and taxes, not just the dividends issued to an investor. This is important because companies that retain earnings may be more likely to grow and be able to issue investors larger dividends in the future.