$1.7 trillion blown on making EPS look less bad.
The S&P 500 index, closing today at 2,373, hovers near its all-time high. Total market capitalization of the 500 companies in the index exceeds $20 trillion, or 106% of US GDP. In the three-plus years since the end of January 2014, the index has soared 33%.
And yet, over these three-plus years, even with financial engineering driven to the utmost state of perfection, including $1.7 trillion in share buybacks and despite “ex-bad-items” accounting schemes that are giving even the SEC goosebumps – despite all these efforts, the crucial and beautifully doctored “adjusted” earnings-per-share, perhaps the single most manipulated metric out there, has gone nowhere.
“Adjusted” earnings per share are back where they’d been at the end of January 2014. It’s a sad sign when not even financial engineering can conjure up the appearance of earnings growth.
Companies report earnings in two ways:
- All companies report as required under GAAP (our slightly inconvenient Generally Accepted Accounting Principles). These earnings are often a loss or way too small and shrinking, instead of growing, and hence not very palatable.
- So most companies also report pro-forma, ex-bad-items, “adjusted” earnings, based on the companies’ own notions of what matters. Analysts and the media hype that metric. This is just a method of reporting the same results in a more glamorous manner.
Then there’s financial engineering. Companies borrowed heavily over the past few years and used those funds to purchase their own shares. This hollowed out equity and left companies with piles of debt. Over the past three years, companies blew $1.7 trillion on share buybacks. This money was not invested in productive activities that would have expanded the company and the economy, and generated cash flow to service this debt. All it did was reduce the number of shares outstanding. This has the effect of increasing earnings per share (EPS) though the company didn’t actually make more money.
Add this system of share buybacks to the system of “adjusting” earnings per share via reporting schemes, and the result should be a miracle of soaring “adjusted” EPS. But no.
For the trailing 12-month period, “adjusted” earnings per share in aggregate for the S&P 500 companies was $109, as of March 16, according to global data provider FactSet, just a hair above where it had been on January 31, 2014:
But over the same period, the S&P 500 index has soared 33%. What gives?
I previously dissected the lack of growth in total adjusted earnings – not earnings per share, but total earnings for the S&P 500 companies. Since this is not a per-share metric, it excludes the effects of financial engineering, such as share buybacks. It showed that total earnings on a 12-month trailing basis in Q4 2016 were stuck at 2011 levels, though the S&P 500 index had soared 87%.
So financial engineering – share buybacks to reduce the number of shares outstanding – works, kind of: It made the results look less terrible. But even these expert financial engineering methods, at a cost of $1.7 trillion, couldn’t doll up results enough to show any kind of earnings growth over the past three years.
Yet stocks have soared despite these miserable growth fundamentals. So what gives in this no-earnings-growth environment?
Turns out the only thing that has soared is the price-earnings multiple. Over the three-plus years, it expanded by 47% from a P/E ratio of 18.15 on January 1, 2014, to P/E ratio of 26.64 today:
This combination of flat earnings and soaring stock prices, and thus expanding P/E ratios, is not uncommon. It comes in cycles: periods of multiple expansion are followed by periods of multiple compression. The current cycle of year-over-year multiple expansion has lasted for 57 months, the longest on record. The prior three record cycles – which ended in 1987, 2000, and 2009 – turned into periods of multiple compression associated with blistering crashes. Read… This is Worse than Before the Last Three Crashes