I previously wrote that an astounding 99% of operating earnings and 108% of reported GAAP earnings, of the S&P 500, were paid out to shareholders, via dividends or share buybacks. This leads to mid to low single digit sustainable growth rates, but it also affects the justified leading and trailing P/E ratios.
I wrote that the justified P/E ratio was low compared to current market valuations. However, if the current rate of shareholder payout rates continue this is not true. I recognized this after having done the research on share buybacks, which unfortunately I did not do before the previous article.
Recall the formula for the justified trailing P/E.
The term (1-b) used to be the dividend payout ratio, but now I'll call it the shareholder payout ratio. I showed in the sustainable growth rate article, that the most recent data shows a 99% shareholder payout of operating earnings and 108.8% shareholder payout of GAAP reported earnings.
I went and found the growth rates for operating EPS to be 6.374%, and reported EPS to be 5.953% over the last 26 years; this data is available from the S&P indices web page and downloaded as an excel file, just look under "Additional Info" and then "Index Earnings."
If an investor takes (1-b) = 1.088, g = 5.953% and r = 8.82% then one gets a justified trailing P/E of 36.59 and justified leading P/E of 34.53 (see original article for leading formula and r calculation). Much higher than the current market.
If an investor takes (1-b) = .99, g = 6.374% and r = 8.82% then the justified trailing P/E is 43.05 and the leading P/E is 40.47!
Wow, much higher than we have now and at levels that in the past have turned out to be market tops. The Seeking Alpha article "S&P 500 Historical P/E Ratio" has a chart going back to 1929, and the empirical data shows that trailing P/E ratios above 30 do not take place very often, if at all.
As investors we have come to a paradox, as I illustrate in the graphic below.
We can see that the large share buybacks taking place have two opposite effects on the stock price. The buyback increases the P/E ratio, and if included in the payout to shareholders, the justified P/E ratio. However, opposed to this is the lower sustainable growth rates, as I showed in a previous article.
The paradox appears to be resolving as follows. Because of low rates, and an extraordinarily accommodative central bank policy, companies have been using debt to grow above the sustainable growth levels of internally generated funds.
Source: St. Louis Fed
Over the last year, debt of nonfinancial US companies has grown 9.4%, on average, over the prior year. This rate of growth is not sustainable with expected nominal long-term GDP growth of 4.3%. Hence, share buybacks will have to slow down in the future.
For the time being these buybacks have created a virtuous cycle, but as George Soros shows, in "The Alchemy of Finance," with his theory of reflexivity, this sets up the cycle turning, in the future, into a vicious one. The companies, which are too aggressive in their buybacks, and use of debt, will have to cut share buybacks. This will depress their share price, which will further increase their cost of equity. When rates raise and companies have to roll over loans this will also hit their bottom lines, and they might even have to raise more equity capital. If a company sells equity it will also decrease its growth rate per share, as the growth becomes diluted by more shares outstanding.
This research has led me to the following conclusions:
- Stocks are "overvalued" by traditional metrics (my previous articles).
- Extraordinary nontraditional monetary policies are allowing unsustainable amounts of stock buybacks and higher than normal valuation metrics.
- Companies that are most aggressive in stock buybacks are very likely possible sources of Alpha in the current environment.
- Companies that are "conservative" with their balance sheet will likely be a negative Alpha drag on the portfolio in the current environment.
- When the environment changes the positive and negative Alpha companies will likely flip; with the conservative companies outperforming and the proliferate, aggressive companies underperforming.
- Research and look for data that would signal a change in the economy or central monetary policy.
- Remember, that list of conservative "lagging" companies will get one ahead of the curve in the future; so do your homework now, to harvest Alpha in the future.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.