Principles: Look-through Earnings
Berkshire Example
When one company owns part of another company, appropriate accounting procedures pertaining to that ownership interest must be selected from one of three major categories. The percentage of voting stock that is owned determines the accounting treatment.
GAAP requires full consolidation of sales, expenses, taxes, net earnings… if more than 50% is owned.
When 20% to 49% owned (commonly called “investees”), there is also full inclusion of net earnings, but unlike the >50% category, all items of revenue and expense are omitted; just the proportional share of net income is included. Whether the investee distributes any earnings or not, this amount is still recorded in the owning company’s P&L.
The interesting ones are holdings representing <20% ownership of another corporation’s voting securities. In these cases, accounting rules dictate that the owning company include only dividends received in their earnings. Undistributed earnings are ignored.
So if your company owns 10% of shares of another company, which produced $10m in earnings and paid out 50% of it as dividends. Then, you will record the proportion ownership of $500k dividends received. However, if it retains all earnings and paid out no dividends, you will record nothing in P&L.
For Berkshire’s case, most of their shareholdings in publicly traded companies pay out a small fraction of earnings as dividends. So we face a very significant accounting and economic reality mismatch; on the accounting side Berkshire’s operating earnings only reflect dividends received, but the economic well-being of Berkshire actually depends on the earnings of these companies, and not how much dividend they payout.
More importantly, Berkshire’s partial ownership of stocks has increased dramatically over time, supported by the success of their insurance business. Furthermore, these stocks happen to be quality businesses that grew earnings over a long period of time.
Because of accounting rules, Berkshire’s reported earnings is only the “tip of an iceberg”. The rest of the iceberg below surface represents the economic earning power of businesses that, as a group, can generate high returns on reinvested earnings, but are not shown explicitly. This is the concept of look-through earnings.
Think about this: Berkshire has 100% ownership of some lousy businesses that are actually worth less than book value, although on paper it seems like Berkshire has “control”, this is only an economic illusion. If they reinvested all their earnings back into these lousy businesses, it would not yield a market rate of return. Yet accounting rules represents these earnings fully.
On the other hand, Berkshire has partial ownership of great businesses like Apple, where every reinvested dollar is able to generate above market returns, yet none of Apple’s earnings are proportionally represented. Only the dividends are accounted for.
The concept of look-through earnings makes clear about the economic reality: The value of Berkshire’s retained earnings is not determined by the level of ownership. Rather, it is how these retained earnings are being reinvested and the subsequent returns on reinvested earnings.
This is where we need to be careful when analyzing companies that grow by M&A. Sometimes, businesses acquire others just to consolidate their P&L and make their earnings look bigger, whether the acquired business is of good prospects need to be assessed independently.
In contrast, a minority stake in an excellent business can be lost in the parent’s P&L because GAAP accounting disallows consolidation. But this is actually economically beneficial.
Another discrepancy that arises from this is that book value has become a less useful measure of intrinsic value. Accounting rules require Berkshire’s equities portfolio asset values to be mark-to-market, yet it doesn’t include look-through earnings.
The opposite happens for above 20% ownership. These entities are included in earnings, but their assets don’t represent market value.
This means that in the past, when majority-owned non-insurance operations were still small, the intrinsic value of Berkshire was linked to book value. But now, these entities grew larger, and book value is no longer a useful estimate of intrinsic value.
Compounding this problem further is the action of shares repurchases below intrinsic value. This will increase the per-share intrinsic value, and decrease the per-share book value, which makes measurements on book value even less reliable.
In most corporations, <20% ownership positions are unimportant (perhaps, in part, because they prevent maximization of cherished reported earnings) and the distinction between accounting and economic results we have just discussed matters little. But in Berkshire’s case, such positions are of very large and growing importance. Their magnitude is what makes Berkshire’s reported operating earnings figure naunced.