Saturday, October 30, 2010

A look at look-through earnings

Warren Buffett once wrote about a concept he called “look-through earnings.” Look-through earnings reflect in the operating income of a company both its share of the earnings paid out as dividends and its share of the operating earnings retained by the companies it has a below 20% stake in. Here’s the formula for look-through earnings: the company’s operating profit + the company’s share of the operating earnings retained by the companies it has a below 20% stake in – the extra taxes it would have to pay if those retained earnings were all paid out as dividends.

Generally accepted accounting principles (GAAP) only let a company take into account the dividends it receives from the companies it owns less than 20% of but not its share of the earnings retained by those companies. GAAP does, however, allow a company to include in its income statement all the earnings (both earnings paid out as dividends and the earnings retained) accrued by its holdings that represent an above 20% ownership interest in another company. This doesn’t make much sense, as a 10% interest in a company should entitle you to 10% of that company’s earnings, just as a 20% or higher ownership interest in a company should entitle you to a 20% or more share in that company’s profit.   

If we don’t look at look-through earnings and just take reported earnings at face value, we can really undervalue some companies and miss out on identifying some really great investment opportunities. Here’s an example:

A holding company that has 2 holdings, the first holding represents a 100% ownership interest in a company that earns $1 million every year, and the second holding represents a 10% ownership interest in a company that earns $100 million every year but don’t pay out any dividends. The holding company will report the full $1 million from its first holding but report $0 from its second holding (although its share of the earnings is $10 million).

This completely disregards the fact that the holding company’s share of the earnings had been reinvested for the holding company’s benefit and can result in the holding company experiencing capital gains and better profitability from its second holding at a later date. With look-through earnings, the holding company will have an operating income of $11 million (for simplicity’s sake, we’ll assume dividend taxes is 0%. Just make sure to make adjustments for dividend taxes in real life) instead of the $1 million in operating income it will report under GAAP.

Companies that can make good use of retained earnings should retain earnings. Assuming that there are 2 investment opportunities and both cost the same and currently generate the same amount of earnings, any company that puts its shareholders first will rather own 1% of a company that reinvests all its profits at good returns (even if the investing company will not be able to report a dime on its income statement) than own 100% of a company that have to reinvest most of its earnings at subpar returns just to maintain current profitability (even if the investing company get to report all the earnings of that company on its income statement).    

At the end of the day, it is not reported profitability but true profitability that will determine the long-term performance of an investment, and to distinguish a company’s true profitability from its reported profitability we need to look at look-through earnings.        

If you have any questions, or if you have anything that you would like to share, please feel free to comment. Thank you for reading, and may you always sustain good returns on your portfolio. Take care.