Serious Money:The Standard & Poor's 500 recently celebrated its 50th birthday, an event that has been accompanied by an unprecedented upturn in corporate profits that has seen earnings-per-share (EPS), advance at double-digit levels in each of the last 19 quarters. Operating cash flows have reached more than $1 trillion (€745 billion) yielding the corporate sector more than ample internal funds to finance growth opportunities.
However, management has been extraordinarily frugal in the amount of money it has been willing to invest in value-creating projects and cash distributions to shareholders have soared. Corporate America has returned more than $1 trillion to owners over the past two years as reinvestment rates have dropped to record lows.
The buy-and-hold advocates of the 1990s bull market purported that stock prices always go up in the long run and that cash distributions are of little consequence.
The historical evidence says that cash distributions account for the bulk of stock market returns in the long run and capital gains in real terms have been decidedly pedestrian. Indeed, real stock prices did not make a new high until 1958 following the infamous peak of 1929 and the apex in 1968 was not surpassed until 1992. The message to be learned must be that fundamentals always win over long horizons.
Cash distributions have advanced sharply in recent years, increasing by 19 per cent per annum to more than $650 billion in the past 12 months.
As cash distributions have reached record levels, corporate America has increasingly used share repurchases as the method of payout, despite the Bush regime's equalisation of tax rates on capital gains and dividend income. Share repurchases by S&P 500 firms have increased by almost 27 per cent per annum over the past five years, while dividend payments have risen at a much more modest rate of almost 10 per cent.
Are share repurchases that good relative to old-fashioned dividends? The answer is no, but the investment community's focus on earnings growth suggests otherwise.
The misguided thinking is best illustrated by way of a simple example. Suppose a firm with 10,000 shares is currently priced at $10 per share or a market capitalisation of $100,000, which consists of an operating business worth $90,000 and excess cash of $10,000. Assume that the firm is earning profits of $6,000 on its core business and interest income of $250 at a deposit rate of 2.5 per cent.
The firm decides to distribute the excess cash of $10,000 to shareholders through the repurchase of shares. The shares are repurchased at $10 a share, which reduces cash and firm value by the said amount. The number of shares drops to 9,000 and the stock price remains exactly the same but the price/earnings (p/e)multiple drops from 16 to 15.
Why does the p/e multiple fall? The value of the firm before the buyback includes the operating business, which is valued at 15 times, and the excess cash, which at an interest rate of 2.5 per cent is valued at 50 times. The p/e multiple of 16 times is a weighted average of the two components. Once the excess cash is distributed to shareholders, the p/e multiple drops to that of the operating business.
The example excludes some of the more important tenets of financial theory - taxes and bankruptcy costs were not considered. The optimal mix of debt and equity involves a trade-off between the marginal tax savings provided by more borrowings and the marginal costs associated with an increased probability of financial distress. The distribution of excess cash should cause share prices to rise - albeit by a small amount - due to a more appropriate mix of debt and equity.
Dividends have historically been the primary delivery vehicle that have ensured that management has not wasted excess cash in value-destroying projects. Furthermore, historical evidence shows companies rarely increase dividends unless management believes that it can be maintained in the long run. Consequently, dividends reflect a company's earnings power.
Share repurchases on the other hand, reflect temporary increases in profitability and move in tandem with the economic cycle. Furthermore, unlike a dividend increase, management is not obliged to complete a buyback programme. Additionally, buybacks do not represent a permanent distribution of excess cash. Repurchased shares remain available for re-issue to fund stock options or acquisitions.
Share repurchases are much-loved in today's financial markets yet the message conveyed to investors is vastly inferior to that of increased dividends. Dividends have been an important component of stock returns through time. They matter - always have and always will.
Charlie Fell is an independent consultant and lectures in finance and investment in UCD and the Institute of Bankers in Ireland.
