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
