My portfolio’s still cheap based on ‘look-through’ earnings

Author: Patrick Larkin

Covestor model: All Cap Value

The principle that buying a stock amounts to buying part ownership in a business is one of the pillars of value investing. The primary benefit of this part ownership is the right to benefit from the earnings of the company, either from receiving dividends or having the earnings reinvested on your behalf at a satisfactory rate of return.

The term look-through earnings refers to an investor’s pro-rated share in the earnings of the companies that he is in invested in. If you own 1% of Pepsico, Inc. (PEP), and the company earns $7 billion dollars in the year, then your look-through earnings attributable to your Pepsico holding are equal to .01*$7 billion, or $70 million dollars.

While the quoted market value of my All-Cap Value portfolio advanced rapidly during the first quarter’s market surge, the portfolio is still cheap based on its look-through earnings. A $100,000 investment made in the stocks comprising the all-cap value portfolio, in proportion to their weightings in the portfolio, would have trailing twelve month look-through earnings of $7,662.78, implying a trailing P/E ratio of 13.04 (data: Yahoo Finance). This is partly the result of the stocks in the portfolio having been cheap when I purchased them, partly due to rising earnings from some stocks in the portfolio, and partly due to the plunge in price of model holding Hewlett Packard (HPQ).

Of course the GAAP earnings used in my calculation of look-through earnings are not always the same as a firm’s “owner earnings,” which can be thought of as the amount of cash that could be withdrawn from a business in a typical year without shrinking the firm or weakening its competitive position.

And of course the P/E ratio is not a definitive determinant of whether a stock is overvalued or undervalued. I could use my own estimates of owner earnings and intrinsic value for each stock, but GAAP earnings and the P/E ratio have the advantage of being verifiable, and studies have found the P/E ratio to be a reasonably good valuation indicator when averaged across portfolios.