The reason
that this 2.8% Add-on to Earnings Growth is so high is because of the extremely
low interest rate environment created by the US Fed. Large Corporations are sitting on massive
amounts of cash. Thus, it is extremely
attractive for them to use this cash to buy back their own common stock.
The way the
math works is that in computing Earnings Per Share, the numerator gets reduced
for the lower Net Income resulting from using this cash. But since this cash is yielding such
incredibly low interest, in essence the numerator is reduced by a very minor
amount by using cash to buy back common shares.
And large
companies that don’t have a sufficient amount of cash can borrow money very
cheaply again due to the extremely low interest rate environment created by the
US Fed.
On the
other hand, the denominator in the EPS computation gets reduced by the number
of common shares bought back by the large company. The end result is a large Add-on increase in
Earnings Per Share, which is what drives common stock prices.
Clearly,
many companies have seen the light and have taken advantage of this very
lucrative economic effect of buying back their own common shares.
And top
executives want their companies to buy back their common shares because these
top executives’ compensation is based predominantly on what happens with the
market price of their companies’ common stock.
Common
stock buybacks have been a common strategy for many years, as you can see from
this post I made several years ago.
However,
since the financial meltdown in late 2008, the economic consequences of common
stock buybacks have been substantially enhanced due to the extremely low
interest rate environment.
Let me
illustrate with some examples.
Let’s
assume a common stock trades for $75, which is 15 times 2012 earnings of $5.00
per share.
Then, let’s
very conservatively assume that its 2013 core earnings grow 4.3%, with a 2.8%
Add-on for common stock buybacks, thus its 2013 EPS grows by 7.1%. And then let’s assume this same earnings
growth over each of the next five years.
Assuming
the common stock continues to sell for 15 times trailing year’s earnings, this
stock would sell for 15 times 2017 EPS of $7.05, or $105.68, in five years, which is an appreciation of 41%
from the current $75.00 price.
But there
are two elements to this 41% stock price appreciation. First, the stock price appreciation based on just
the core Total Annual Earnings Growth of 4.3% is 23.4% and second, the stock price
appreciation based on the Add-on to EPS due to common stock buybacks is another
17.4%.
If you
change the assumption and assume the core annual Total Earnings Growth is 6.3% per
year instead of 4.3%, and with the same 2.8% Add-on to EPS due to common stock
buybacks, then the stock would sell for $115.93 in five years, with 55% total stock
price appreciation. 19% of this 55%
total stock price appreciation would be due to the common stock buybacks.
If you change the assumption and assume the core annual Total Earnings Growth is 8.3% per year instead of 4.3%, and with the same 2.8% Add-on to EPS due to common stock buybacks, then the stock would sell for $126.95 in five years, with 69% total stock price appreciation. 20% of this 69% total stock price appreciation would be due to the common stock buybacks.
And if you
change the assumption and assume the core annual Total Earnings Growth is 10.3% per
year instead of 4.3%, and with the same 2.8% Add-on to EPS due to common stock
buybacks, then the stock would sell for $138.80 in five years, with 85% total stock
price appreciation. 22% of this 85%
total stock price appreciation would be due to the common stock buybacks.
And if you
make the same assumptions over ten years, the stock price appreciation due to
just common stock buybacks ranges from 46% assuming 4.3% core Total annual
Earnings Growth to 76% assuming 10.3% core Total Annual Earnings Growth.
Given the
incredibly lucrative impact on stock price appreciation due to just common
stock buybacks, let me now assume that a company steps up its common stock buybacks by
doubling its 2.8% Add-on EPS due to common stock buybacks to 5.6%.
In this case, the stock price appreciation in five years due just to the common stock buybacks ranges from 37% assuming a 4.3% core Annual Earnings Growth to 46% assuming a 10.3% core Annual Earnings Growth. And the stock price appreciation in ten years due just to the common stock buybacks ranges from 105% assuming a 4.3% core Annual Earnings Growth to 171% assuming a 10.3% core Annual Earnings Growth.
So clearly
the US Fed has done economic wonders for large corporations and their top
executives here.
But are common stock buybacks fair to everyone? Clearly not, since
individuals and small businesses can’t take advantage of these incredibly
lucrative common stock buyback opportunities.
And
common stock buybacks do absolutely nothing to grow the US economy or to increase US jobs.
What they
do is further expand substantially the economic gap between the wealthy and
everyone else.
And large
corporations are motivated not to hire people because of this incredibly lucrative low interest rate
environment. Why? Because the US Fed has publicly stated that
it will continue to create this extremely low interest rate environment until
US unemployment drops to 6.5%. In other
words, this incredibly lucrative common stock buyback strategy becomes less
lucrative to large corporations once US unemployment drops to 6.5%.
My hunch is
that US unemployment will not drop to 6.5% for many years. And when it finally drops
to 6.5%, it will take many additional years for the US Fed to unwind its massive amounts
of debt investments. Thus, interest
rates will remain very low for many, many years.
I think
these extremely lucrative common stock buybacks are the main reason for the US stock market rising so robustly so
far in 2013. And given the stock price
appreciation due to common stock buybacks in my various scenarios, I think the US stock market should be higher
than it now is, even given how much it has already gone up so far in 2013.
Below here
are the detailed computations of the various Stock Price Appreciation scenarios:
| Stock Selling for $75, which is 15X trailing year's $5.00 EPS Earnings | |||||||||||
| 4.3% | 7.1% | 6.3% | 9.1% | 8.3% | 11.1% | 10.3% | 13.1% | ||||
| Average | Average | Average | Average | Average | Average | Average | Average | ||||
| Annual | Annual | Annual | Annual | Annual | Annual | Annual | Annual | ||||
| EPS | EPS | EPS | EPS | EPS | EPS | EPS | EPS | ||||
| Growth | Growth | Growth | Growth | Growth | Growth | Growth | Growth | ||||
| EPS in Year | Rate | Rate | Rate | Rate | Rate | Rate | Rate | Rate | |||
| 2012 | $5.00 | $5.00 | $5.00 | $5.00 | $5.00 | $5.00 | $5.00 | $5.00 | |||
| 2013 | $5.22 | $5.36 | $5.32 | $5.46 | $5.42 | $5.56 | $5.52 | $5.66 | |||
| 2014 | $5.44 | $5.74 | $5.65 | $5.95 | $5.86 | $6.17 | $6.08 | $6.40 | |||
| 2015 | $5.67 | $6.14 | $6.01 | $6.49 | $6.35 | $6.86 | $6.71 | $7.23 | |||
| 2016 | $5.92 | $6.58 | $6.38 | $7.08 | $6.88 | $7.62 | $7.40 | $8.18 | |||
| 2017 | $6.17 | $7.05 | $6.79 | $7.73 | $7.45 | $8.46 | $8.16 | $9.25 | |||
| 2018 | $6.44 | $7.55 | $7.21 | $8.43 | $8.07 | $9.40 | $9.00 | $10.47 | |||
| 2019 | $6.71 | $8.08 | $7.67 | $9.20 | $8.74 | $10.45 | $9.93 | $11.84 | |||
| 2020 | $7.00 | $8.66 | $8.15 | $10.04 | $9.46 | $11.61 | $10.95 | $13.39 | |||
| 2021 | $7.30 | $9.27 | $8.67 | $10.95 | $10.25 | $12.89 | $12.08 | $15.14 | |||
| 2022 | $7.62 | $9.93 | $9.21 | $11.95 | $11.10 | $14.33 | $13.33 | $17.12 | |||
| Stock Price in 5 Years | $92.57 | $105.68 | $101.80 | $115.93 | $111.74 | $126.95 | $122.44 | $138.80 | |||
| Stock Price Appreciation in 5 Years | 23% | 41% | 36% | 55% | 49% | 69% | 63% | 85% | |||
| Add On Stock Price Appreciation in 5 Years Due Stock Buybacks | 17% | 19% | 20% | 22% | |||||||
| Stock Price in 10 Years | $114.26 | $148.92 | $138.16 | $179.19 | $166.47 | $214.88 | $199.90 | $256.85 | |||
| Stock Price Appreciation in 10 Years | 52% | 99% | 84% | 139% | 122% | 187% | 167% | 242% | |||
| Add On Stock Price Appreciation in 10 Years Due to Stock Buybacks | 46% | 55% | 65% | 76% | |||||||
| Assume Double EPS Annual Growth Add-On For Common Stock Buybacks from 2.8% to 5.6% | |||||||||||
| 4.3% | 9.9% | 6.3% | 11.9% | 8.3% | 13.9% | 10.3% | 15.9% | ||||
| Average | Average | Average | Average | Average | Average | Average | Average | ||||
| Annual | Annual | Annual | Annual | Annual | Annual | Annual | Annual | ||||
| EPS | EPS | EPS | EPS | EPS | EPS | EPS | EPS | ||||
| Growth | Growth | Growth | Growth | Growth | Growth | Growth | Growth | ||||
| EPS in Year | Rate | Rate | Rate | Rate | Rate | Rate | Rate | Rate | |||
| 2012 | $5.00 | $5.00 | $5.00 | $5.00 | $5.00 | $5.00 | $5.00 | $5.00 | |||
| 2013 | $5.22 | $5.50 | $5.32 | $5.60 | $5.42 | $5.70 | $5.52 | $5.80 | |||
| 2014 | $5.44 | $6.04 | $5.65 | $6.26 | $5.86 | $6.49 | $6.08 | $6.72 | |||
| 2015 | $5.67 | $6.64 | $6.01 | $7.01 | $6.35 | $7.39 | $6.71 | $7.78 | |||
| 2016 | $5.92 | $7.29 | $6.38 | $7.84 | $6.88 | $8.42 | $7.40 | $9.02 | |||
| 2017 | $6.17 | $8.02 | $6.79 | $8.77 | $7.45 | $9.58 | $8.16 | $10.46 | |||
| 2018 | $6.44 | $8.81 | $7.21 | $9.82 | $8.07 | $10.92 | $9.00 | $12.12 | |||
| 2019 | $6.71 | $9.68 | $7.67 | $10.98 | $8.74 | $12.43 | $9.93 | $14.05 | |||
| 2020 | $7.00 | $10.64 | $8.15 | $12.29 | $9.46 | $14.16 | $10.95 | $16.28 | |||
| 2021 | $7.30 | $11.69 | $8.67 | $13.75 | $10.25 | $16.13 | $12.08 | $18.87 | |||
| 2022 | $7.62 | $12.85 | $9.21 | $15.39 | $11.10 | $18.37 | $13.33 | $21.87 | |||
| Stock Price in 5 Years | $92.57 | $120.24 | $101.80 | $131.59 | $111.74 | $143.77 | $122.44 | $156.85 | |||
| Stock Price Appreciation in 5 Years | 23% | 60% | 36% | 75% | 49% | 92% | 63% | 109% | |||
| Add-On Stock Price Appreciation in 5 Years Due to Stock Buybacks | 37% | 40% | 43% | 46% | |||||||
| Stock Price in 10 Years | $114.26 | $192.77 | $138.16 | $230.87 | $166.47 | $275.61 | $199.90 | $328.02 | |||
| Stock Price Appreciation in 10 Years | 52% | 157% | 84% | 208% | 122% | 267% | 167% | 337% | |||
| Add-On Stock Price Appreciation in 10 Years Due to Stock Buybacks | 105% | 124% | 146% | 171% | |||||||
