Every now and then, I like to take an afternoon away from my stock research, find a comfortable chair, pull out my collection of old Berkshire Hathaway (NYSE:BRK.A) annual reports, and start reading.
Even though I must've read through all the annual reports from 1977 to the present at least five times, I find that with each rereading, I'm able to focus on something different that helps me to become a better investor. Most every value investor, it seems, has his favorite "Buffettism" -- some idea or concept that Warren Buffett has described in his teachings about investing over the past 40-plus years.
My favorite Buffettism is a concept I've found to be immensely helpful in portfolio management. The idea is "look-through" earnings, which Buffett introduced as such for the first time in his 1990 annual letter to explain how he evaluates Berkshire's large equity holdings. But it wasn't until the 1991 shareholder letter that he encouraged his readers to use the concept in their own investing. Here's an extract from that letter:
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.
Applying the look-through concept
Applying the look-through concept to your own portfolio is relatively simple, and I bet the results will surprise you. First off, forget that your portfolio is made up of a bunch of individual stocks that may have no relation to each other. Instead, pretend you are running a business-holding company, and that each individual stock represents a "business unit" of your own little conglomerate. Let's say, for example, that you have this portfolio:
Company Shares Price Value
Coca-Cola (NYSE:KO) 20 $40.41 $808.20 Microsoft (NYSE:MSFT) 50 $25.74 $1,287.00Home Depot (NYSE:HD) 100 $27.65 $2,765.00Pfizer (NYSE:PFE) 20 $31.82 $636.40T. Rowe Price (NASDAQ:TROW) 40 $30.34 $1,213.60
Total Market Value $6,710.20
As you can see, the market value of your little conglomerate is $6,710.20. The second step is to "look through" the stocks into the earnings power of the companies underneath. Using 2002 full-year earnings for all companies (which, for Home Depot, will be fiscal 2003 ending on Feb. 2, 2003) -- except for Microsoft, for which we will use the trailing 12-month earnings ending March 31, 2003 -- here are the look-through earnings:
Company EPS Shares Earnings
Coca-Cola $1.65 20 $33.00 Microsoft $0.88 50 $44.00Home Depot $1.56 100 $156.00 Pfizer $1.47 20 $29.40T. Rowe Price $1.52 40 $60.80
Total Look-Through Earnings $323.20
Now, what does this mean? For one thing, it can tell you what you are paying on a weighted-average basis for the companies in your portfolio relative to their demonstrated earnings power.
In this case, our imaginary investor is paying $6,710.20 for a basket of underlying assets, with demonstrated annual earnings power of $323.20. That comes out to a weighted-average P/E ratio of 20.8, which isn't too bad considering that the S&P 500 carried a weighted-average P/E ratio of 27.37 as of March 31, according to Barra.
Since the companies in this portfolio represent the crème de la crème of the S&P 500, getting the above package at a discount of 24% from the index would seem to be a pretty decent bargain. Looked at another way, the portfolio above has an "earnings yield" of 4.8% on a look-through basis, versus 3.65% for the S&P 500 as a whole. Of course, the weighted-average P/E multiple of our portfolio is skewed somewhat due to the heavy weighting of Home Depot, but the information is no less valuable for that. Most individual investors tend to have one or two stocks that dominate their portfolios, and the look-through method can help them identify those.
I encourage you to do the above exercise with your portfolio. If you are like me, you will be very surprised at the result. The first time, I discovered I was paying above 50 times earnings on a look-through basis. And I thought I was a value investor! As it turned out, I had a couple of development-stage biotechs, one or two other unprofitable companies, and one stock with a P/E multiple of over 100 in my portfolio at the time -- and it doesn't take many of those to make for some crazy numbers. It was definitely good for me to see the look-through effect that even a couple of "speculative" stocks can have on a portfolio.
A friend of mine, who likes to invest in "emerging" technology stocks, actually has a negative earnings yield for his portfolio -- meaning that, as a group, his portfolio of investments reported negative earnings over the past year, and his "business units" burn cash rather than produce it. That's probably not a good thing.
On the other extreme, true-blue value investors might want to construct a portfolio of stocks with a weighted average P/E ratio of, say, 10 or less. This would result in an "earnings yield" of 10% or better, assuming those companies, as a group, were able to maintain their earnings power in future years.
Look-through dividend yield, free cash flow, and other fun ideas
Once you get the hang of the concept, it is easy to run the numbers for a bunch of other metrics on your portfolio. For example, I have calculated the look-through dividend yield for the sample portfolio below:
Company DIVPS Shares Dividends
Coca-Cola $0.88 20 $17.60 Microsoft $0.08 50 $4.00Home Depot $0.24 100 $24.00 Pfizer $0.60 20 $12.00T. Rowe Price $0.68 40 $27.20 Total Look-Through Dividends $84.80
As you can see, our portfolio looks like it will pay out $84.80 in dividends in the upcoming year, for a 1.26% yield based upon our current market value of $6,710.20. That's quite a bit less than the S&P 500's 2.12%, as of March 31. Having one stock with a puny yield, like Microsoft, dramatically lowers the weighted-average yield of a portfolio with otherwise respectable dividends.
Personally, I like to use free cash flow as my favorite look-through metric, and I try to ensure that the weighted price-to-free cash flow ratio generally remains low so as to keep my free cash flow yield to a level that approximates a reasonable annual return. You might also want to do a look-through analysis using conservative one-year forward estimates of earnings or cash flow for each of your stocks, or extend the concept to include balance sheet data. For example, do you have any idea of the weighted cash-to-debt or debt-to-equity ratio of your portfolio? You might want to find out.
The look-through concept is tremendously useful. I think you will learn a lot about your portfolio by playing with some of the ideas presented here, and you'll have a lot better idea of what's really in your wallet.
Zeke Ashton has been a longtime contributor to The Motley Fool, and is the managing partner of Centaur Capital Partners, LP, a money management firm in Dallas, Texas. Please send your feedback to [email protected].
