In the 1982 Letter to Shareholders of Berkshire Hathaway, Warren Buffett included spent a few paragraphs explaining the accounting realities that come into play based on whether or not you own at least 20% of a company in which you invest. Basically, it works like this: if you own less than 20% of a company, your balance sheet only reflects the dividends that the company pays to you on the balance sheet. If you own more than 20% of the company, your balance sheet reflects both the dividends that the company pays you and the retained earnings that the company keeps.
As Buffett put it in 1982:
“The appended financial statements reflect “accounting” earnings that generally include our proportionate share of earnings from any underlying business in which our ownership is at least 20%. Below the 20% ownership figure, however, only our share of dividends paid by the underlying business units is included in our accounting numbers; undistributed earnings of such less-than-20%-owned businesses are totally ignored.
There are a few exceptions to this rule; e.g., we own about 35% of GEICO Corporation but, because we have assigned our voting rights, the company is treated for accounting purposes as a less-than-20% holding. Thus, dividends received from GEICO in 1982 of $3.5 million after tax are the only item included in our “accounting”earnings. An additional $23 million that represents our share of GEICO’s undistributed operating earnings for 1982 is totally excluded from our reported operating earnings. If GEICO had earned less money in 1982 but had paid an additional $1 million in dividends, our reported earnings would have been larger despite the poorer business results. Conversely, if GEICO had earned an additional $100 million – and retained it all – our reported earnings would have been unchanged. Clearly “accounting” earnings can seriously misrepresent economic reality.
We prefer a concept of “economic” earnings that includes all undistributed earnings, regardless of ownership percentage. In our view, the value to all owners of the retained earnings of a business enterprise is determined by the effectiveness with which those earnings are used – and not by the size of one’s ownership percentage. If you have owned .01 of 1% of Berkshire during the past decade, you have benefited economically in full measure from your share of our retained earnings, no matter what your accounting system. Proportionately, you have done just as well as if you had owned the magic 20%. But if you have owned 100% of a great many capital-intensive businesses during the decade, retained earnings that were credited fully and with painstaking precision to you under standard accounting methods have resulted in minor or zero economic value. This is not a criticism of accounting procedures. We would not like to have the job of designing a better system. It’s simply to say that managers and investors alike must understand that accounting numbers are the beginning, not the end, of business valuation.
In most corporations, less-than-20% ownership positions are unimportant (perhaps, in part, because they prevent maximization of cherished reported earnings) and the distinction between accounting and economic results we have just discussed matters little. But in our own case, such positions are of very large and growing importance. Their magnitude, we believe, is what makes our reported operating earnings figure of limited significance.”
From a literal perspective, this may not mean a whole lot to those of you that do not own operating companies. But does it have some usefulness for those of us that are common stock investors with a dividend focus.
If we only look to the dividend payout, we will only know what the company’s dividend is doing now. But a look at a company’s retained earnings can help us get a handle on what kind of dividend growth to expect going forward into the future.
For instance, right now, AT&T is paying out a $0.45 quarterly dividend. That means they are paying shareholders $1.80 per year for every share of AT&T stock that they own. But AT&T has only been generating $2.33 per share in profit. That means that $0.77 of every dollar that the company generates in profit is going towards paying shareholders a dividend. Logistically speaking, management only gets to use $0.23 on the dollar to buy back stock, pay down debt, and grow the company so that it can make even larger dividend payments in the future.
Contrast that with a big oil company like Royal Dutch Shell. Right now, Shell is pumping out $8.31 in profits for shareholders each year. The company mails shareholders $3.60 of that $8.31 as a dividend this year. That means that $0.43 on the dollar is spoken for, and the Shell Oil management team gets to use $0.57 of each dollar that the company makes in profit to buy back stock, pay down debt, or grow the company. Shell Oil has more excess profit at its disposal to fund future dividend growth than AT&T does (although AT&T is a non-cyclical stock that can rely upon steady cash flow from which to pay shareholders each year, whereas Royal Dutch Shell is an oil company that experiences low profits for 2-3 out of every ten due to the cyclical nature of oil and natural gas prices).
As dividend investors, we are different from others because we focus on the cash sent to our checking account every ninety days instead of the market price of the stocks we own. But there can be a temptation to only focus on the profits that the company pays out to us, at the risk of neglecting the earnings that the management team retains. Those retained earnings matter. They are what fund future dividend growth. Anytime you consider a potential investment, you should keep an eye on the amount of retained earnings as much as the immediate dividend that you are going to receive.