As the second quarter earnings season draws to a close, it’s become clear that earnings-per-share valuations are not as trustworthy as they once were.
Companies are increasingly announcing share buybacks as a way to trick the market and manipulate the equation used to determine the price to earnings (P/E) ratio. If a company buys back shares, the P/E number is likely to decrease – making it look like a better investment. When is beats earnings expectations, investors will then be incentivised to buy shares – pushing the share price back up, and maintaining the status quo.
Jefferies’ Sean Darby wrote in a client note on Tuesday, “On reflection 1Q earnings were not only poor but were exaggerated by huge share buybacks. The second highest ever quarterly buyback (around US$167bn) meaningfully contributed to EPS even though the overall number was poor.”
However, the markets are likely to start wising up. Democratic presidential candidate Hillary Clinton has recently spoken out against share buybacks, criticising them for pleasing “activist” hedge funds. The Democrats have also championed the Brokaw Act, designed to making it harder for hedge funds to influence companies and prevent “short-termism in the economy”.
However, it seems companies may have already shot themselves in the foot. Share prices have risen so much it would be uneconomical for companies to buy back their shares, with buyback announcements slowing to their lowers level since 2012 during the second quarter of 2016.
Like it so often does, the market appears to be regulating itself in this area. As investors begin to mistrust earnings reports, companies will have less incentive to buy them back – taking everyone back to square one.