The Buffett Series - Look-Through Earnings

The Buffett Series explores some of the interesting and timeless investment concepts discussed by Mr. Buffett in his annual Berkshire letters.  Over the years I've found there isn't a lot that Mr. Buffett and his partner Mr. Munger haven't worked out when it comes to investing. I am constantly discovering hidden investment gems, new ways of thinking about businesses and the investment process.  

This Series contains ten short essays on concepts that have featured in Mr. Buffett's annual letters since the early 1980's.  It's amazing how timeless and universal they are.  This short essay touches on the concept of "Look-Through Earnings".

Buffett focuses on the earnings that are generated by the companies he owns.  While a company may pay out some of the earnings it generates in the form of dividends, the retained earnings are no less valuable to an investor.  In fact, if the company can retain and reinvest those earnings at a high rate of return, the investor is better served by the company doing so.  Such companies are often referred to as compounding machines.  

Buffett recognises that while the price of a company's shares can fluctuate regardless of fundamentals over the short term, over the long term changes in the company's share price will reflect changes in the company's earnings.  

In his 1991 letter, Buffett advised investors ...

"We also believe that investors can benefit by focusing on their own look-through earnings. To calculate these, they should determine the underlying earnings attributable to the shares they hold in their portfolio and total these. The goal of each investor should be to create a portfolio (in effect, a "company") that will deliver him or her the highest possible look-through earnings a decade or so from now.  

An approach of this kind will force the investor to think about long-term business prospects rather than short-term stock market prospects, a perspective likely to improve results. It's true, of course, that, in the long run, the scoreboard for investment decisions is market price. But prices will be determined by future earnings. In investing, just as in baseball, to put runs on the scoreboard one must watch the playing field, not the scoreboard."

In the 1994 letter Buffett related Berkshire's growth target with look-through earnings ...

"If our intrinsic value is to grow at our target rate of 15%, our look-through earnings, over time, must also grow at about that pace"

In his 1996 letter Buffett once again advised …

"Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio's market value. Though it's seldom recognized, this is the exact approach that has produced gains for Berkshire shareholders: 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."

Many successful investors adopt Buffett's approach to focus on earnings.  Rather than focus on short term share prices they seek to build a portfolio whose earnings will grow over time.  

“Note that I have no interest in the development of share prices. This is why I don’t waste your time with a discussion of the fund’s or individual company’s price development. If a company regularly increases its earnings power, the share price will track this over time. A robust investment process correctly identifies companies which increase their earnings power. A rising share price is the outcome. My sights are firmly trained on process.”  Robert Vinall

“At Giverny Capital, we do not evaluate the quality of an investment by the short-term fluctuations in its stock price. Our wiring is such that we consider ourselves owners of the companies in which we invest. Consequently, we study the growth in earnings of our companies and their long-term outlook.” Francois Rochon

Paying a reasonable price for a portfolio of quality companies that can compound earnings in the years ahead is likely to deliver attractive returns.