Look-Through Earnings
The Value of Retained Earnings and Cash Dividends
During the first half of the twentieth century, Wall Street believed
that companies existed primarily to pay dividends to shareholders. The
past fifty years, however, have witnessed the acceptance of the more
sophisticated notion that the profits not paid out as dividends that
are reinvested in the business also increase shareholder wealth by
expanding the companys operations through organic growth and
acquisitions or strengthening the shareholders position through debt
reduction or share repurchase programs.
Berkshire Hathaway Chairman and CEO, Warren Buffett, created a metric
for the average investor known as look-through earnings to account for
both the money paid out to investors and the money retained by the
business.
The theory behind his look-through earnings concept is that all
corporate profits benefit shareholders whether they are paid out as
cash dividends or plowed back into the company. Successful investing,
according to Buffett, is purchasing the most look-through earnings at
the lowest cost and allowing the portfolio to appreciate over time.
Calculating Look-Through Earnings
Normally, a company reports basic and diluted earnings per share
(e.g., the Washington Post reported diluted earnings per share of
$25.12 for fiscal year ended 2003.) Sometimes, a portion of the profit
is paid out to shareholders in the form of a cash dividend (e.g., the
Washington Post paid a $7.00 cash dividend to shareholders.) Put
another way, of the $25.12 diluted earnings per share profit earned by
the company, $7.00 was sent to each shareholder in the form a dividend
check they could take to their bank and cash and the remaining $18.12
was reinvested in the Washington Posts core businesses which include
newspapers, educational services and cable stations. Ignoring stock
price fluctuation, an investor that owned 100 shares of Washington
Post common stock would have received $700 cash dividends at the end
of one year (100 shares x $7 per share dividend.) Logically, however,
the $1,812 that belonged to the shareholder and was reinvested in the
Posts business has very real economic value and cannot be ignored,
despite the fact that he never actually received the money directly.
In theory, the reinvested profit will result in a higher stock price
over time.
As mentioned above, Buffetts look-through earnings attempt to fully
account for all of the profits that belong to an investor - both those
retained and those paid out as dividends. Look-through earnings can be
calculated by taking an investors pro-rated share of a companys
profits and deducting the taxes that would be due if all profits were
received as a cash dividends. To illustrate this point: assume John
Smith, an average investor, has a portfolio consisting of two
securities the common stock of retailing giant Wal-Mart and that of
soft drink juggernaut Coca-Cola. Both of these companies pay a portion
of their earnings out as dividends, but if John was to only regard the
cash dividends received as income, he would ignore most of the money
that was accruing to his benefit. To truly see how his investments are
performing, John needs to calculate his look-through earnings. In
effect, he is answering the question, how much after-tax cash would I
have today if the companies I owned paid out 100% of the reported
profit?
Stock Position 1: Wal-Mart
Wal-Mart reported diluted earnings per share of $2.03 for the most
recent fiscal year. John is in the 20% tax bracket and owns 5,000
shares of Wal-Mart. His look-through earnings, therefore, are as
follows: $2.03 diluted earnings x 5,000 shares = $10,150 pre-tax * [1
- .20 (tax rate)] = $8,120.
Stock Position 2: Coca-Cola
Coca-Cola reported diluted earnings per share of $1.77 for the most
recent fiscal year. John owns 12,000 shares of the companys common
stock. His look through earnings can be calculated as follows: $1.77
diluted earnings x 12,000 shares = $21,240 pre-tax [1-.20 (tax rate)]
= $16,992.
Total Look-Through Earnings for Entire Portfolio
By tabulating the total look-through earnings generated by his stock
holdings, we discover that John has look-through earnings of $25,112.
It would be a mistake for him to only pay attention to the $11,040*
that was received as cash dividends on an after-tax basis. Common
sense tells us that the other $14,072 that had been plowed back into
the two companies, were accruing to his benefit and certainly have
value.
Look-Through Earnings
How Look-Through Earnings Determine Buy and Sell Decisions
When should John sell his Coca-Cola or Wal-Mart positions? If he is
convinced that another investment opportunity will allow him to
purchase substantially more look-through earnings and that company
enjoys the same sort of stability in earnings due to regulation or
competitive position, he may be justified in selling his shares and
moving into the other company (note that in the case of Wal-Mart and
Coca-Cola, however, it is unlikely one is going to find a corporation
with comparable competitive advantages and economics.) Benjamin
Graham, father of value investing and author of Security Analysis and
The Intelligent Investor, recommended the investor insist on at least
20% to 30% additional earnings to justify selling one position and
moving into another.
Furthermore, John needs to evaluate his investment performance by the
operating results of the business, not the stock quote. If his
look-through earnings are steadily growing and management a
shareholder-friendly orientation, the stock price is only a concern in
that it will allow him to purchase additional shares at an attractive
price; these fluctuations are merely the lunacy of Mr. Market. The
$25,112 in look-through earnings John calculated is every bit as real
to his wealth as if he owned a car wash, apartment building or
pharmacy. By investing from a business perspective, John is better
able to make intelligent, rather than emotional, decisions. As long as
the competitive position of either company has not changed, John
should view significant drops in the price of Wal-Mart and Coca-Colas
common stock as an opportunity to acquire additional look-through
earnings at a bargain price.
The Importance of Look-Through Earnings in Corporate Analysis
Many corporations invest in other businesses. Under Generally Accepted
Accounting Principles (GAAP), the earnings of these investment
holdings are reported in one of three ways: the cost method, the
equity method or the consolidated method. The cost method is applied
to holdings that represent under twenty percent voting control; it
only accounts for dividends received by the investing corporation.
This shortcoming is what caused Buffett to expound on the
undistributed earnings in his shareholder letters; Berkshire, both
then and now, had substantial investments in companies such as
Coca-Cola, the Washington Post, Gillette, and American Express. These
companies pay out only a small portion of their overall earnings in
the form of dividends and, as a result, Berkshire was accruing far
more wealth to owners than was evident in the financial statements.
For more information, see Minority Interests on the Income Statement
The Cost Method, Equity Method and Consolidated Methodp.
**Calculation of cash-dividends on an after-tax basis: $0.36 per share
cash dividends * 5,000 shares = $1,800 * [1 - .20 (tax rate)] = $1,440
after-taxes $1.00 per share cash dividends *12,000 shares = $12,000
*[1 .20 (tax rate)] = $9,600 after-taxes
----------------------------------------------- $11,040 total
after-tax cash dividends received
