It’s Cash Flow

What drives the stock market?

Dow Jones Industrial Average, log scale. Source: Bloomberg

In the short run, stock market returns are driven by buyers and sellers. More buyers than sellers drive prices up; more sellers than buyers push prices down. In the long run, though, the market is determined by how much cash companies give to their shareholders. This is the heart of any firm’s valuation. When companies pay dividends or buy back shares, they are distributing cash to their owners. It’s the present value of these future cash flows that determine what a company is worth.

In the past, the way companies paid their shareholders was through the dividend. The stock market’s dividend yield used to be higher than the bond market’s yield, because investors understood that dividends were risky. In contrast to the bond market, where coupon payments are contractual, dividends can be cut at any time. But dividends are tax-inefficient: the company pays a corporate income tax on its earnings, and the shareholders pay income taxes on dividend payments.

So companies began buying back their shares, particularly in the ‘70s. Now, the market’s yield from share buybacks is slightly higher than the yield from dividend payments. Currently, the combined yield from dividends and buybacks is about 4.5%.

Source: Financial Analysts Journal

And where do companies get the cash to make dividend payments and buybacks? Over the long run, they have to get it from free cash flow. Free cash flow is a company’s cash from operations minus the money needed for ongoing capital expenditures. Money spent on new production facilities is the same – from a cash-flow perspective – as that spent on employee salaries or executive perks. It’s not available to shareholders. When you look at the growth in total payouts to shareholders, it roughly follows the growth in per-capital GDP.

Source: Financial Analysts Journal

This is what you would expect. In the aggregate, company payouts can only grow as the economy grows. Over time, both of these measures have grown at about 1.7%

This has profound implications for what we can expect from the stock market. Historically, analysts looked at dividends and corporate earnings as the two sources of the market’s total return. But ignoring share buybacks leads us to underestimate the market’s potential growth. Historically, the market has produced around a 6% long-term real return – total return minus inflation. Currently, analysts expect closer to 3 ½% real returns. But when you add 2% buyback yields in, expectations are much closer to their long-term averages.

How companies invest their cash matters. Some stock buybacks destroy value. When Dell purchased its own shares at $40, then $30, then $20, and then went private at $15, their cash died and went to money heaven. But when a growing company devotes a portion of a growing stream of free cash flow to purchase its own shares, this adds additional value to shareholders.

In the short run, market prices adjust to balance the supply and demand for company shares. But in the long run, it’s dividends and buybacks, driven by corporate free cash flow, that really determines returns.

Douglas R. Tengdin, CFA

By |2017-10-26T07:27:52+00:00October 26th, 2017|Global Market Update|0 Comments

About the Author:

Mr. Tengdin is the Chief Investment Officer at Charter Trust Company and author of “The Global Market Update”. The audio version of each post can be heard on radio stations throughout New England every weekday. Mr. Tengdin graduated from Dartmouth College, Magna Cum Laude. He received his Master of Arts from Trinity Divinity School, Magna Cum Laude and received his Chartered Financial Analyst (CFA) designation in 1992. Mr. Tengdin has been managing investment portfolios for over 30 years, working for Bank of Boston, State Street Global Advisors, Citibank – Tunisia, and Banknorth Group. Throughout his career, Mr. Tengdin has emphasized helping clients manage their financial risks in difficult environments where they can profit from investing in diverse assets in diverse settings. - Leave a comment if you have any questions—I read them all! - And Follow me on Twitter @GlobalMarketUpd

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