Historically the S&P 500 was considered overbought — and ripe for a bear market — when the dividend yield dropped below 3 percent. A surge in share buybacks in the past two decades, however, disrupted this relationship, with the dividend yield falling close to 1.0 percent in the Dotcom era.
What happens when we adjust for share buybacks?
In 2011, S&P 500 share buybacks increased to $409.0 billion. With dividends of $298 billion*, that gives a total cash distribution (dividends and buybacks) of $707 billion for a yield of 5.44 percent. Right in the middle of the 5.0 to 6.0 percent range previously considered typical of an oversold market.
* S&P 500 market capitalization of $12,993 billion at June 29, 2012 multiplied by 2.29 percent
Unfortunately share buybacks fluctuate wildly with the state of the market:
If we omit the highest and lowest readings, and take the average share buyback over the remaining 3 years, it amounts to $349 billion. That would give adjusted total cash distributions of $614 billion and an adjusted yield of 4.98 percent — still close to the oversold range.
Compare to Earnings Yield
The current reported earnings yield of 6.8 percent, however, is way below the highs (10 to 14 percent) of the 1970s and 80s. Current distributions (dividends plus buybacks) amount to 80 percent of current earnings. Payout ratios above 60 percent are considered unsustainable.
My conclusion is that earnings yield offers a more accurate measure of value. And reflects a market that is fairly valued — rather than overbought or oversold — especially when we consider the likelihood of earnings disappointments.
Thanks for your always interesting commentary. However, I disagree with your following comment.
“In 2011, S&P 500 share buybacks increased to $409.0 billion. With dividends of $298 billion*, that gives a total cash distribution (dividends and buybacks) of $707 billion for a yield of 5.44 percent. Right in the middle of the 5.0 to 6.0 percent range previously considered typical of an oversold market.”
I dispute that share buybacks are a form of “distribution” to shareholders in general. In fact, the only shares bought back are those that have been placed up for sale by a shareholder. Therefore, the selling shareholder would have received its proceeds regardless of whether the company bought the shares or some other entity.
Share buybacks have only three mathematically certain outcomes.
1. Cash shrinks…all else equal.
2. LOWER total dividend distributions are made given the lower number of shares outstanding.
3. EPS will be higher…or at least down less than they otherwise would be.
But my point is that share buybacks do not DIRECTLY put any money in shareholder bank accounts…other than those who intended to sell their shares anyway and therefore ought not to be considered a “distribution.” Conversely, a dividend payment directly benefits every single shareholders and therefore is a “distribution” in every sense.
Regards,
Jim
Share buybacks are classed as distributions to shareholders for the following reasons:
For example, if Company A has 100 shares and makes a profit of $100 which it distributes by way of dividend, each share will receive a $1 dividend and be valued at $10 if the PE is 10.
The company uses $100 of its cash reserves and buys back 10 shares. Profits will be reduced to $98 after loss of interest earned at say 2% on the $100. But earnings and dividends will increase to $1.0889 per share ($98/90 shares remaining) and each share will be valued at $10.89 at a PE of 10. An increase in value of 89 cents per share.
That is lower than the $1.00 per share that would have been received if the cash reserves had been used to pay a dividend. But profits of $98 would then be distributed over 100 shares ($0.98 per share) and value would fall to $9.80. Total value (including dividend) of $10.80 is lower than for the share buyback. When we consider that buybacks also have tax advantages, we can understand their popularity.