You'll notice that the cost method, which applies to holdings under 20%, only allows the company to report the cash it actually receives in the form of dividends as income. This can be misleading. If your company owned 15% of Microsoft, for the first 25+ years, you didn't see a dime in dividends, although your 15% share of the earnings was being reinvested in the business on your behalf by management and would have amounted to several billion dollars. Those earnings will subsequently lead to long-term rise in the value of your stock holding, and are therefore very important to your economic future.
Don't believe it? Say you inherit a business that your great-grandfather founded a century ago. At the end of every year, he used some of the business' profits to buy shares of Thomas Edison's company, General Electric. By the time the company came under your control in 2002, it owned 19% of GE's common stock (1,888,600,000 shares). General Electric paid a dividend that year of $0.72 per share. According to GAAP accounting rules, your business could only report the $1,359,792,000 in dividends you received.
However, the year before, General Electric had actually made a profit of $14.6 billion, of which, nineteen percent indirectly belonged to you. Although you could only report $1.36 billion in dividends, you actually have a legal ownership to $2.774 billion in the company's earnings ($1.36 billion were paid out to you as dividends, with the remaining $1.4 billion retained by GE for future expansion). This means that you were not allowed to report more than $1.4 billion in earnings that indirectly belonged to you.
The general logic states that because you never see that money, it shouldn't count as income. This is both misinformed and dangerous. The entire $2.774 billion belongs to you. The portion of the earnings that were not paid out will be reinvested into GE's business and subsequently result in a rise in the stock price. If someone were to value the business, they would include the entire $2.774 billion in their calculation because the entire amount was working to your economic benefit.
In Some Cases, A Huge Portion of a Company's Profits Won't Be Seen on the Income Statement Due to Accounting Rules
Famed investor Warren Buffett referred to these unreported profits as look-through earnings. The successful investor strives to put together a portfolio with the highest possible look-through earnings for each dollar invested. This will result in market-beating returns. In his 1980 Letter to Shareholders of Berkshire Hathaway, Buffett explained that Berkshire's income statement was reporting less than half of what the company's true economic earnings were due to the rules governing minority interests:
"Our holdings in this [20% or less] category of companies [has] increased dramatically in recent years as our insurance business has prospered and as securities markets have presented particularly attractive opportunities in the common stock area. The large increase in such holdings, plus the growth of earnings experienced by those partially-owned companies, has produced an unusual result; the part of 'our' earnings that these companies retained last year (the part not paid to us in dividends) exceeded the total reported annual operating earnings of Berkshire Hathaway. Thus, conventional accounting only allows less than half of our earnings "iceberg" to appear above the surface, in plain view."
The lesson is clear: You must add the non-reportable earnings of a company's partially owned businesses back into the income statement to come up with an accurate estimate of economic earnings.
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This page is part of Investing Lesson 4 - How to Read an Income Statement. To go back to the beginning, see the Table of Contents.
