In yesterday’s post about revenue growth and profit margins, we talked about how the significant tailwinds that have benefited the markets over the past couple of years may well be playing out. With that in mind, if company earnings are looking to—at best—grow at significantly slower rates than they have over the past couple of years, does that mean similar results for the stock market?
Not necessarily. Stock prices are based on shares, not companies. The relevant metric, therefore, is earnings per share (EPS), not company earnings. The two are obviously connected; however, while company earnings growth may slow, EPS growth doesn’t have to lag to the same extent.
Indeed, if a company changes the number of shares outstanding, EPS growth can continue at stronger levels even as earnings growth slows. For any given stream of earnings, reducing the number of shares outstanding will increase the EPS. In order to maintain EPS growth in the face of slowing earnings growth, corporations have embraced this solution in the form of stock buybacks.
Over the past several years, we’ve seen stock repurchases at very high levels, from around 2 percent to almost 6 percent of market capitalization per year. Put another way, at one point, companies were buying back stock at a pace that would have taken the whole S&P 500 private in about 16 years.
Two factors are behind the gross level of stock buybacks as a percentage of market capitalization. One is the level of stock prices. At lower stock price levels, an equal dollar purchase will retire a greater percentage of the total shares in the market. The second factor is the absolute dollar amount used to repurchase shares.
In both cases, what matters is the trend. If markets are rising or at high levels, the effect of any given dollar amount will be less, as it will buy and retire fewer shares. Conversely, if the dollar amount deployed by companies to buy shares declines, that will also have less of an effect.
Markets are currently at high levels and continuing to rise, which suggests that the buoying effect of stock buybacks may be less for a given dollar amount. As we have seen with earnings, a tailwind is easing off as it becomes more expensive for companies to repurchase enough shares to make a difference.
What would make up for this is an absolute increase in the dollar amount used to repurchase shares. Here again, we’ve had historically very high rates of dollar purchases for share retirement over the past several years—generally more than $50 billion per quarter—which has supported the growth in EPS. The dollars deployed for repurchases are declining, though, and that, combined with overall higher stock prices, will make buybacks less effective as a tool for maintaining EPS growth levels.
As with revenues and profit margins, companies have benefited from several EPS-supporting tailwinds over the past couple of years that have led to very strong performance. Now, the trends have changed, and we can’t expect to see that kind of positive support going forward. While there’s nothing to indicate a substantial decline in these measures, looking ahead, the rate of growth should be less than in recent history. To the extent that markets expect the growth of the past couple of years to continue, caution seems appropriate.