Volume 21, No. 5

Growing, Glowing Earnings: S&P 500's 2011 Untaxed Income:  When can earnings be too good? When they’re growing, but glowing like they’re radioactive - and shareholders can’t get their hands on them. That’s what happens when firms "indefinitely reinvest" their earnings in low-tax countries. The earnings in those subsidiaries look wonderful, they can generate cash copiously - but they won’t benefit shareholders directly because diverting those earnings to the United States will trigger tax liabilities. The earnings and generated cash stick in those countries. In other words, they’re radioactive earnings - glowing, but just too hot to handle.

Consolidated financial statements present a unified picture of a firm’s financial status and operating performance. The problem: that unified picture doesn’t tell investors one thing about the degree to which earnings, cash flow and cash itself may be trapped in a foreign country. Often, those countries with a sub-U.S. tax rate also offer other advantages over operating in the United States. They may provide access to lower-cost labor, operate in a less-regulated environment, or simply be geographically closer to a targeted market. In short, there can be plenty of reasons making it desirable for firms to invest outside the U.S. - and aside from taxes, they can accelerate earnings growth beyond those of U.S. operations. Because of the lower taxes and potentially better margins, they can take a company’s overall earnings growth from the ordinary to the excellent. That earnings source for some firms in the S&P 500 may have nearly doubled the entire index’s earnings growth over the last five years from 2.2% to 3.8%. (And it’s not just because of Apple.)

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