Berkshire Hathaway looks cheap based on its cash-adjusted price to “look-through” earnings ratio

Buffett has always viewed GAAP accounting as a starting point for understanding the economics of a business. Years ago, in this regard, he introduced the idea of “look-through” earnings. The idea is that Berkshire’s share of unreported earnings – primarily those generated and retained by businesses in its sizable equity portfolio – are just as valuable as the earnings it does report under GAAP.

Here’s what Buffett said about the matter in his 1989 letter to shareholders:

In our view, Berkshire’s fundamental earning power is best measured by a “look-through” approach, in which we append our share of the operating earnings retained by our investees to our own reported operating earnings, excluding capital gains in both instances.

And here’s more on the subject from the Berkshire Hathaway Owner’s Manual:

Accounting consequences do not influence our operating or capital-allocation decisions. When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles than to purchase $1 of earnings that is reportable. This is precisely the choice that often faces us since entire businesses (whose earnings will be fully reportable) frequently sell for double the pro-rata price of small portions (whose earnings will be largely unreportable). In aggregate and over time, we expect the unreported earnings to be fully reflected in our intrinsic business value through capital gains.

We have found over time that the 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 benefitted 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.

As I wrote about a couple of days ago, Barron’s in its January 22, 2011 article on Buffett and Berkshire Hathaway entitled “Mr. Moneybags” states that Berkshire’s 2011 earnings are, “On track to hit a record $12 billion to $13 billion after taxes.” That would be $7,500 to $8,000 per share in 2011.

However, because this figure excludes “look-through” earnings, it materially understates Berkshire’s true economic earnings. By my rough calculation based on consensus 2011 analyst estimates, Berkshire will earn an additional $1,680 per share from its share of the earnings of its equity holdings net of dividends. In the past and I assume to be conservative, Buffett also subtracted taxes from the look-through earnings as if they were paid out as dividends. I did not do this as no taxes are actually assessed and given Berkshire’s history of low turnover.

Here is my data.

That means Berkshire’s look-through earnings are on track to be between approximately $9,200 and $9,700 for 2011.  Given its current share price of approximately $124,000 per A share and that Barron’s reasonably projects it will have approximately $30,000 a share in cash at the end of 2011 (or $50,000 billion), Berkshire is currently selling at only about 10 times it cash-adjusted 2011 earnings. Using a market multiple of 15 times earnings would imply that Berkshire Hathaway is worth approximately $170,000 per share.

That’s pretty cheap for a basket of world-class companies that were hand-picked by Warren Buffett and which enjoy a formidable collection of incentivized, proven, entrepreneurial, owner-oriented mangers.


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