Stock Buybacks and the Equity Premium

Update 1 pulled up here (Dean Baker says current dividends plus share buybacks are unsustainable)

Update 2 Nick Bunker considers the dramatic example of Apple and the issue of unsustainable payouts to shareholders.

The point of this post is to try to estimate the sustainable long run expected real return on US common stock. Historically, the long run average return has been roughly 7% per year vastly greater than the safe real interest rate. This means that over all historical 30 year periods, US common stock has yielded a higher return than bonds. However, price earnings ratios are much higher than they were for much of the 20th century, so it doesn’t seem plausible that common stock could pay 7% real per year over long periods starting now.

Dean Baker challenged economists to come up with a story for how they could forecast 7% real returns (I can’t find the link). OK so I will.

First I will assume that the ratio of market capitalization to GDP won’t have a long term trend. US Real GDP growth has averaged about 3% per year since 973, so I assume that the value of the stock market will grow about 3% per year. Currently the S&P 500 dividend yield is about 1.9%. I guess (but don’t find the numbers) that the overall market dividend yield is higher, so I use 1.9%. So far I have 4.9% real return, well below 7%.

However, holding the market also requires buying newly issued shares and selling shares when corporations buy them back. In the USA corporations buy more shares from households than they sell — share buybacks are greater than public offerings. Net selling to the corporate sector is an additional source of returns. Share buybacks have recently been massive involving more dollars than were paid in dividends.

stock buybacks—more than $6.9 trillion of them since 2004, according to data compiled by Mustafa Erdem Sakinç of The Academic-Industry Research Network. Over the past decade, the companies that make up the S&P 500 have spent an astounding 54 percent of profits on stock buybacks. Last year alone, U.S. corporations spent about $700 billion, or roughly 4 percent of GDP, to prop up their share prices by repurchasing their own stock.

Last year’s buybacks were about 3.3% of market capitalization.

The reader may have noticed that I wrote “public offerings” not “initial public offerings”. It is possible for an existing joint stock corporation to issue new shares diluting the old shares. This is very tightly regulated and is very rare in the USA. Google keeps sending me to IPO when I ask for public offerings, so I will guess that recently all US public offerings were initial public offerings. IPO volume is much higher when share prices are high. Also 2014 had an extraordinarily high level compared to the rest of the past 10 years. That level was $ 85.2 billion less than 13% of the volume of share buybacks. I will assume that 2014 is the new normal and subtract 0.4% per year to pay for newly issued shares.

So my final back of the envelope guess of likely long term real returns is 7.8% per year*.

It seems to me that the equity premium is alive and well.

*arithmetic corrected.

update: Dean Baker responds. I like his post except that the title includes “Robert (not Paul) Waldman” which makes me think of “Robert (not Paul) Samuelson” and I sure hope Robert Waldmann isn’t to Paul Waldman as Robert Samuelson is to Paul Samuelson.

He pointed out that stock buybacks plus dividends of 5.2% of market capitalization are more than 100 % of profits (currently almost exactly 5% of market capitalization). To invest in physical capital (as they are) corporations have to be spending their financial assets or borrowing. This isn’t sustainable.

I am convinced. With a price earnings ratio of 20, there can’t be a dividend plus share buyback yield of 5.2% *and* growth of 3% without increased leverage and leverage can’t increase forever.

My tired front of the envelope guess is that with corporate debt equal to book equity (about right) both real fixed capital (K) and real debt growing at 3% per year, and no trends in relative prices, the ratio of reinvested profits to fixed capital has to be 1.5%. Here the calculation is increased real debt for a fixed debt/K ratio pays for half of the growth of K.

Market capitalization is somewhat greater than but roughly equal to nonfinancial assets so I think balanced growth of 3% per year requires a ratio of reinvested profits to market capitalization of somewhat less than 1.5%. So with a earnings/price ratio of 5% profits available for buybacks and dividends are about 3.5% and the sustainable return for everything balanced is about 6.5%.

For growth = 2% not 3% the sustainable return would be about 6%.