The importance of undistributed earnings

Modern portfolio theory suggests you should value stocks based on the sum of discounted dividend cash flows — called the dividend discount model (DDM).

But while dividends are a tangible benefit to investing in equities, DDM doesn’t consider earnings retained and reinvested for the benefit of shareholders.

For the most part, if a company owns at least 20% of an entity, the proportional share of that entity’s net earnings must be included in the owner’s income statement.

On the other hand, if the company owns less than 20% of an entity, accounting rules say the company has no significant influence on that entity. So only the dividends received from these holdings are recorded on the company’s books. Undistributed earnings are ignored.

But they shouldn’t be: they are reinvested into the company to increase future earnings and dividends for shareholders.

For most publicly traded entities, only a small fraction of earnings are paid out as dividends (sometimes none at all). This leaves the majority of earnings power unaccounted for. When valuing a company that owns less than 20% of other companies, each investor will assess its value differently.

To overcome the limitations of accounting, Warren Buffett created a metric, called look-through earnings, to analyze the overall earnings-generating capabilities of a firm. The theory is that all corporate profits benefit shareholders, whether paid out as cash dividends or reinvested into the company.

For instance, at the end of 2012, Buffett reported his company Berkshire Hathaway had significant ownership in American Express, Coca-Cola, IBM and Wells Fargo. And while the look-through earnings for these holdings amounted to $3.9 billion, only $1.1 billion of those were reported on the company’s financials. This leaves $2.8 billion of earning power unaccounted for.

Similarly, Berkshire’s earnings per share was $8,977. If we were able to include the $2.8 billion of unreported earnings, earnings per share would grow by $1,697, giving us look-through earnings that amount to $10,674 per share — a figure 19% higher than the one reported.

The value of undistributed earnings

Although look-through earnings can be useful in valuing investments, and assessing opportunities, the real value lies in how those retained earnings are deployed. So investors need to judge whether the retained earnings are as valuable as those reported.

Whether a company is using the funds to expand operations, make acquisitions, repurchase shares, or reduce debt load, retained earnings will best serve shareholders if the company can employ incremental capital to their advantage.

Investors should search for great businesses with significant reinvestment opportunities that are likely to produce high rates of return.

Just as Buffett calculates look-through earnings to attain a more accurate valuation of Berkshire, investors can adopt a similar valuation approach for the holdings in their portfolios to determine true long-term profitability potential.

Susy Abbondi is a portfolio manager at Duncan Ross Associates.