You’ve worked hard to get where you’re at. You take pride in your work. And it pays you well. It requires long hours of work, but you’re okay with that. On your commute each morning you’ve discovered some great books to listen to: The Intelligent Investor, The Bogleheads’ Guide to Investing, and more.
Listening to many books on personal finance has taught you two important ideas:
- you must save and invest a portion of your income, and
- compound interest is the key to obtaining wealth.
Table of Contents
A Story of an Investor
About 2 years ago, you decided to start saving and investing seriously. You chose four known companies that you believe in and use their products: Apple, Google, Taiwan Semiconductor, and Restoration Hardware. You went a step further and purchased their stock.
Over these 2 years, you’ve managed to increase your savings and have purchased additional shares of these companies. Now your portfolio is worth more than $500,000. Congratulations! You’re doing such a great job at saving and investing.
Here is what your portfolio looks like:
The question you are asking yourself now is, “How is my portfolio doing? Will it do well in the long-term, say over 10 years?” Of course, no one knows the future, but there is one way to analyze this and it’s used by one of the greatest investors of all time, Warren Buffett.
The Concept of Look-Through Earnings
A concept you can use to analyze your portfolio is referred to as Look-Through Earnings (LTE). It is a simple idea to understand your portfolio and roughly gauge how well it will perform over time. The concept is straightforward: each company in your portfolio should earn a profit each year. The LTE is your share of these profits.
For example: Google’s latest reported yearly earnings (2021) was $5.61 per share.
Since you own 1,250 shares of Google, your share of the earnings is: (1,250 shares) * ($5.61 per share) = $7,012.50.
Following this same approach, you can now calculate your share of each of the companies’ earnings. And if you sum up all of these, you obtain the portfolio’s Look-Through Earnings (LTE).
This is an ideal way to monitor your portfolio’s performance on a quarterly or yearly basis. This concept shows how much additional value your money generated through earnings. This is different than your actual portfolio dollar value. Using this method is a much better way to understand how your portfolio itself and the companies within your portfolio are performing.
Warren Buffett is a huge fan of LTE. He uses it as a benchmark for all the Berkshire portfolio companies, and it’s one of the few topics he consistently discusses in his annual shareholder letter, year after year. Another frequent topic is insurance float, discussed in detail in one of my recent articles.
Here’s what he said in his 1990 Annual letter to his shareholders:
Almost every shareholder letter that Buffett wrote from 1989 to 2000 had a section on LTE. In fact, many of these letters have a table like the one we have below that shows how to figure out Berkshire’s LTE. In the letter from 1994, for instance:
One point to consider: if every company in the portfolio decided to distribute all of its revenues as dividends, we would be required to pay additional taxes on these payouts. Buffett’s personal LTE estimates take this into account. To keep this simple, these calculations, however, do not.
So far, we’ve demonstrated how to determine the current LTE of the portfolio. The hard question is, “What is the expected LTE growth in the future, and what metric can we look at to help us understand this?”
We’ve gathered in Buffett’s 1991 letter to shareholders, he suggests that we think about LTE, a decade or so later in the future. This forces us, as investors, to think more about the longevity and long-term earnings of a company, rather than shorter time periods. After all, investing is for the long-term, and the longer we can hold onto the company, the larger the potential earnings. We all know that Buffett does like to buy and hold forever.
How to Use Look Through Earnings
How do we look at this LTE to help us measure the growth and profitability of a company? We use a metric called “incremental return on retained earnings.” In simpler words, it’s the amount that the company grows its earnings, based on how much money it holds onto, rather than distributing it to shareholders. This metric is extremely important in understanding how efficient and effective management is at capital allocation – or reinvesting profits. Let’s review this metric with an example.
Taiwan Semiconductors Manufacturing Company (TSMC)
This time we’ll use Taiwan Semiconductors Manufacturing Company (TSMC).
- In 2015, TSMC earned $1.86 per share.
- By 2021, it has grown to $4.12 per share.
- So how was TSMC able to grow by $2.26 per share? ($4.12-$1.86)
- The answer is: retained earnings (the difference between earnings and dividends paid).
From 2015 to 2020, TSMC earned a total of $14.15 per share. But it did not return all of its earnings to shareholders in the form of dividends. In fact, it returned only $6.38 as dividends. So, where is the other $7.77 in earnings? It goes into retained earnings.
This is the money that was earned by TSMC and was not given back to the shareholders. Instead, it chose to hold onto this money and reinvest it back into the company with their expectation to earn a larger profit for the shareholders. In this case, they would expand operations, research and development, and purchase infrastructure.
This $7.77 of retained earnings from 2015-2020 enabled the company to produce more earnings for shareholders. The retained earnings effectively enabled it to increase its earnings by 29.09% using the money it retained: ($2.26/$7.77) = 29.09%.
Google, Inc. (GOOGL)
Google (GOOGL) earned $1.14 in 2015 and grew to $4.12 in 2021 – growing by $2.26 in earnings per share. You may also see that GOOGL pays no dividends, so it is able to reinvest all of its earnings back into the company for additional growth.
So how did the remaining companies in the portfolio grow?
- Google grew its earnings from $1.14 in 2015 to $5.61 in 2021.
- Unlike TSMC, Google continues to hold all of its earnings and not distribute any dividends to its shareholders.
- Google had the fastest earnings growth rate (25.56%) by a slight margin over Restoration Hardware (24.08%).
- We found that Restoration Hardware had the highest incremental return (41.77%) on retained earnings.
- Google and Restoration Hardware are the companies that pay NO dividends, which allows them to grow the company at a faster rate.
Growth Depends on How the Capital Is Used
An Important Lesson: Earnings growth alone does not provide you everything you need to know. You must also look at the amount of capital that has to be invested back into the company (in the form of retained earnings) to achieve this earnings growth. Then look at the incremental return on this capital. If every dollar is kept and put back into the company every year, you may increase earnings far more quickly.
It is significantly more difficult to maintain earnings growth while paying out a sizable portion of earnings as dividends to shareholders each year. Companies that distribute a significant portion of their profits as dividends will typically grow at a slower rate versus companies that retain all the earnings. But these companies may still be able to generate great incremental returns on the capital invested, which in the long run can be better for the shareholders.
Early-Stage Company Growth
Accelerated (early-growth) stage companies sometimes do not turn a profit for years. If this is the case, a more thorough analysis must be done to adjust earnings. Items such as research and development, marketing, and customer acquisition costs would need to be recalculated to reach a conclusion on profitability. Corporate public accounting practices require companies to expense these items up-front, rather than depreciate them causing higher than normal expenses. This in effect is paying up-font for future revenues, but in the short-term, it causes profits results in losses on the bottom line.
Back to our portfolio. Based on how much each portfolio company made over the past 6 years and how much they distributed as dividends – we can see their payout ratios.
Side note: Buffett is a huge proponent of investing in companies that return cash to its shareholders, as opposed to growth-oriented companies. Nearly all of Berkshire’s equity stock portfolio companies pay dividends each year. He doesn’t mind slower incremental growth when a company consistently returns cash.
This concept of Look-Through Earnings helps you gauge a company’s performance, as well as your overall portfolio performance. When evaluating your portfolio as a whole, it’s called an aggregation metric. Look-through earnings can be used as a yardstick, to see how your portfolio is performing over periods of time. Looking at the broader portfolio and gauging its return on reinvested capital, can tell much more about a portfolio, than by simply looking at stock price, earnings, net income, or even free cash flow. Long-term investing requires sustainable growth over a long period of time. After all, we’re investing for the future, not for the now. Repeat after me, “Buy and hold forever.”
Conclusion
Measuring your portfolios Look-Through Earnings is a great way to understand your portfolio’s growth and how it’s performing, relative to previous periods.
It will also provide you a sense of direction in the future as to, if it is performing up to its expectations, and where the weaker area(s) might be. This is a much better approach to measure the health of your portfolio, rather than only looking at the value of the portfolio based on stock prices.
Warren Buffett discusses the fact that he tries to ignore economic expectations and simply focuses on company performance and share price. During hard economic times, companies can still perform extremely well, and might even be offered at a considerable discount despite their performance. Understanding metrics, such as the incremental return on earnings, can provide a great deal of insight into a company’s performance.