An investor puts his money in a company to earn dividends at the end of an accounting period. This has been the belief before Warren Buffet coined look through earnings in the 20th century. These earrings are called hidden earnings in accounting terms. It attempts to explain an investor’s earnings as a whole. Warren Buffet believes that in as much as it does not go directly to the investor as cash dividends, it contributes greatly to the future earnings of the same dividends.
The retained earrings help a stock to grow. This is because a company increases and enhances growth in its core business by using the retained earnings. The growth in business operations means that a shareholder will be in a position to earn similar amount of cash dividend in future. This assuredness mitigates risk and works towards enhancing the timeliness of a company. This futuristic company outlook assures a company of ability to pay dividends.
Look through earnings are calculated as follows: If all the profits were received as cash dividends, less all the taxes that would be accrued if that is the case the we get the look through earnings. Most companies retain most of these profits. In theory, the case is that stock value will increase over time to the benefit of the shareholder.
Berkshire hatchway, the holding company owned by Warren Buffet, takes advantage of this accounting model. His company owns many shares in many companies. Sometimes, he owns majority shareholding. This means he makes major investment decisions in a company. His, is not an interest in earning cash dividends. Rather, his intention is to see the continuous growth and expansion of the company he owns majority stake.
This means that his intention is to see the growth of his company (a holding company) through the growth of other companies. Look through earnings helps a compnay to ‘look through’ earnings with the cheapest price possible. Then, a company becomes even more attractive to shareholders. This means, that trading of its shares in exchanges intensifies. Although this may not form the core business of the company, it is actually a product of the successful core business that a company carries out. Hence, it can be termed a ‘snowballing effect’. Investors will try as much as possible to put their money in the company because of its good standing in the market.
The generally accepted accounting principles requires that a company have 20% of shareholding investments at most. Warren buffet circumvents this requirement by having many holding companies registered as different shareholders although under the umbrella of Berkshire Hathway. This ensures that he has majority stake if not whole ownership of the company.
Although it looks more theoretical than practical, it is a model of doing business that makes a lot of sense especially for long-term investors like Buffet. He takes advantage of the frequent daily trading at the exchanges to grow the share meaning he increase chances of getting more dividends and entrenches his roots in the company future. Therefore, unlike the name given to it by accountants i.e. hidden earnings, they are actually real earnings although ‘ignored’ when paying out dividends. However, an investor will take advantage of these earnings if the company is in a healthy state of affairs. Hence, Warren’s notion of looking at who owns the tree.