In today’s WSJ ("The S&P Gets Its Earnings Wrong"), Wharton professor Jeremy Siegel (my former economics teacher) argues that Standard & Poor’s miscalculates earnings, and so the S&P 500’s price/earnings (P/E) ratio is lower than reported (hence stocks are cheap). Both Standard & Poor’s and Siegel are wrong. They are missing the forest for the trees. P/E ratios themselves are the problem, because the “E” is fictitious.
Earnings numbers are bunk – with all the various gaps and fudges GAAP allows, a company’s net income and earnings per share is at best a weak indicator of the actual economic value of a firm. More likely, the earnings number is some CFO’s deception. In the bubble, i-bankers and promoters were successful at using these false numbers to get suckers to buy stocks and bonds. But the suckers didn’t even learn after the tech crash in 2001. Today, after the credit crash and our current mini-depression, investors are turning again to what matters: cash. Dividend yields matter - dividends are paid with cash. Stock buybacks matter - buybacks are made with cash. Debt assumed or debt-paid-off matter - debt is cash borrowed or paid back. Asset values matter (but only if the assets produce cash or can be sold for cash!). Shrewd businesspeople - what a rational investor should emulate, per Ben Graham and common sense - look at these numbers, and they are not easily reduced to a single figure or ratio. The closest ratio is something like a price/cash flow ratio, where cash flow is sensibly defined as the sensible “free cash flow” (FCF) calculation (not EBITDA, but cashflow after taxes, interest, and capital expenditures are paid – the sustainable cash that can be distributed out of a company). Generally, FCF can be used to pay dividends, buy back stock, or make acquisitions or capital improvements to improve the company (and generate higher FCFs). So let’s look at what matters.
Dividends: From December 1936 through March 31 2008 the average dividend yield for the S&P 500 was 3.828% vs. 3.833% for December 2007. It peaked at nearly 12% in 1932, and fell to a low about 1.2% in 2000 (the median from 1925 to 2007 was about 3.87%). The current 12-month dividend yield is 2.14% vs. the 1.89% yield for December 2007. The yield is based on the cash dividends paid over the prior four quarters and the closing quarterly price. Does this means companies how gotten worse by paying lower dividends? Not really. While the secular trend has been for a dividend yield under 3%, when you add back non-debt financed stock buybacks, it was probably between 3% to 4%.
Stock Buybacks: When these come from debt or leveraged buyouts, they’re part of the credit bubble. Real buybacks come from FCFs (or selling assets, which isn’t sustainable). For Q3 2008, Standard & Poor's announced S&P 500 stock buybacks of $89.7 billion, representing a 47.8% decline over the record setting $172.0 billion spent during the third quarter of 2007. On a sector basis, Standard & Poor's notes that Energy was the only sector to increase buybacks during the third quarter of '08 versus the third quarter of '07. Information Technology continued to account for a quarter of all buybacks, with Energy now accounting for 18%. That reflects the real value created in these two sectors, unlike the chimerical returns from “Financials” (taking on debt to pay off equity). Since the buyback boom began during the fourth quarter of 2004, S&P 500 issues have spent approximately $1.73 trillion on stock buybacks compared to $1.87 trillion on Capital Expenditures and $907 billion on dividends. If you sum the three, earnings numbers (the “E”) would be near $4.4 trillion, but as a shareholder, you can’t consume capital expenditures.
For investors in stocks, only dividends and buybacks matter, that is, cash paid out (or expectations of future payouts - read up on John Burr Williams and his original dividend discount model). While asset values are important, you can’t consume assets (a car plant has little value to you and me). Companies have been manipulating earnings for too long – I just don’t trust those numbers. While some have started manipulating their cash numbers by taking out debt to do buybacks or pay dividends, that can’t last either. Cash is difficult to manipulate. It is trustworthy, and so a P/FCF number has validity (it must be examined in context of a company’s capital structure). P/E numbers are just marketing ratios that bankers and their credit-agency accomplices put out to fool investors.