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 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.
