The Art of Seeing Beyond: Look- Through Earnings

"Forgotten but not gone"

Look- through earnings, a financial concept popularized by Warren Buffett, allows the intelligent investor to account for both the profits that are paid out to investors as dividends and those retained by the company.

Why is calculating Look- Through earnings necessary?

Firstly, let’s start with some accounting rules: If a company owns less than a 20% stake in another company, the owning company can only include dividends received from the investee in its earnings and the undistributed earnings are basically ignored and unaccounted for by the owning company. This created an issue for companies like Berkshire Hathaway which has ownership stakes of less than 20% in numerous companies. So, if Berkshire had a less than 20% stake in a company that paid no dividend, they would have to record $0 in their earnings with regards to that company. This accounting rule gives a limited recognition of earnings as it gives the notion that the undistributed profits possess no economic value to the shareholder.

Secondly, investors hyperfocus on dividends as a measure of a company’s success overshadowed the economic significance of profits not distributed to shareholders. Even though this hyperfocus on dividends by investors has decreased of late, there is still group of investors who base their investment decisions on whether a company pays a dividend and the dividend yield.

Look- through earnings allow us to assign value and focus on undistributed profits. I would argue that undistributed earnings in the hands of quality management creates more shareholder value than tax inefficient dividends. I should emphasize that the value of the retained profits isn’t based on the size of one’s ownership but on how they are utilized by management. Retained profits can be used for:

1.      Organic Growth

2.      Reducing Debt

3.      Acquisitions

4.      Stock Buybacks

Despite the fact that the profits are not in the hands of the investors, if management intelligently allocates the undistributed profits, there will be an increase in the intrinsic value of the business and the investor will benefit from the subsequent rise in the company’s stock price.

Let’s go into some calculations. We calculate look- through earnings by “taking an investors pro- rated share of a company’s profit and deducting the taxes that would be due if all profits were received as cash dividends.” So, it is basically the amount of cash one would have if the company decided to pay out 100% of all its profits as a dividend.

Lowe’s (NYSE: LOW) had a diluted EPS of $12.04 in 2022. Let’s say you owned 7000 shares of Lowe’s and dividends are taxed at 15%.

   $12.04 x 7000= $84 280 (How much would be paid out to you assuming all earnings are paid out as dividends)

   $84280 x 15%= $12 642 (This is how much you would have been taxed)

Thus, the Look- through earnings are:

  $84280 - $12642= $71 638

Embracing the concept of look-through earnings can be a game-changer for investors and financial analysts seeking a deeper understanding of a company's true financial performance and investment potential. Warren Buffett preaches that the goal of every investor should be to buy the most look- through earnings at the lowest price.