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 company’s operations through organic growth and acquisitions or strengthening the shareholder’s 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.

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 Post’s 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 Post’s 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, Buffett’s 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 investor’s pro-rated share of a company’s 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 company’s 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-Cola’s 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 Method.

**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
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$11,040 total after-tax cash dividends received