Expectations Are High for Continued and Impressive Earnings Growth

8/7/2019 Expectations Are High for Continued and Impressive Earnings Growth

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Execaions Ae High fo Coninue

an Imessive Eanings Gowh

This week marks the start o “Earnings Season” or the rst quarter o the year. Thisis a quarterly ritual on Wall Street where companies report their actual nancialresults or the most recent quarter (earnings, sales, cash fow, costs, etc.), andanalysts use these actual results to update their longer-term orecasts or theprospects o companies, including their target share price and sell or buyrecommendations. Most observers expect to see a continuation o the impressiveearnings growth that began in early 2009 as the economy was still struggling to

exit the Great Recession. This recovery o U.S. corporations rom the recessionhas been the one bright spot or our economy, which (otherwise) continues tostruggle with high unemployment, record government budget decits and aweak housing market.

Trends in Performance for the S&P 500

The Standard & Poor’s 500 Index is a composite measure o stock priceperormance or the 500 largest publicly-traded companies as measured bythe size o their market capitalization (i.e., the total market value o their equityas determined by their share price and number o shares outstanding). It is notan investible index but oten used as a barometer o how well U.S. companies(particularly large-cap companies) are doing.

In addition to measuring composite trends in stock price, many analysts alsocombine other nancial aspects o all the companies in the S&P 500 Index asi to treat them as a single combined entity or mega-corporation. That meansthe income statements, balance sheets and statements o cash fow which eachcompany in the index releases quarterly (as part o the earnings season) arecombined into one income statement, balance sheet and cash fow statementprimarily or the purpose o conducting trend analysis using current and historicaldata. While the results are not specic to any one company, this analysis helpsillustrate how large businesses (generally) are perorming in the U.S. andglobal economies.

WEEkly MArkEt UpdAtE AprIl 12 , 2011

Jim Finnegan, CFA

Investment Writer



WEEkly MArkEt Upd AtE

The chart below plots our measures o perormance or the S&P 500 Indexcompanies rom the second quarter o 1998 to the ourth quarter o last year on atrailing our-quarter (12-month) basis. Each o these measures is based on a com-bined “per share” basis. Sales per share measures the combined reported revenueso the companies. Earnings per share is the net reported prots (ater tax). Free cashfow per share is a measure o the amount o cash the combined companies used(negative number) or generated (positive number) based on their operating activities(making and selling goods and services), investment activities (e.g., building plants,acquiring or selling businesses) and nancing activities (e.g., issuing equity, paying odebt). And EBITDA per share (where the acronym stands or earnings beore interesttaxes, depreciation or amortization) is a proxy or operating prot that can be com-pared among companies with diering capital structures (i.e., capital intensity, amounto leverage) because it measures prot beore the eects o debt (interest expense)or capital depreciation or amortization.

The chart illustrates how sales per share and EBITDA per share have still not

recovered (as o the ourth quarter last year) to levels seen just prior to the GreatRecession. That’s understandable given the indebtedness o many households andthe high rates o unemployment which have both crimped consumer spending. Buton the other hand, earnings per share or the combined S&P 500 companies havenearly recovered to pre-recession levels (and will likely do so with the announcemento rst quarter earnings). And ree cash fow per share exceeds its pre-recessionlevels. These our trends refect how corporations have cut back substantially onemployment costs, overhead expense and investing activities in order to generateimpressive earnings and ree cash fow per share growth in an environment wheresales and operating prots (as measured by EBITDA per share) have struggledto recover.


Sales per share and

EBITDA per share have

still not recovered (as o

the ourth quarter last year)

to levels seen just prior to

the Great Recession. That’s

understandable given the

indebtedness o many

households and the high

rates o unemployment

which have both crimped

consumer spending. But on

the other hand, earnings per

share or the combined

S&P 500 companies have

nearly recovered to pre-

recession levels.

$0

$50

$100

$150

$200

$250

Source: Bloomberg

Sales pe

r Share (Trailing 4 Quarters)

Quarter/Year

EBITDA, Earnings and Free Cash Flow Per Share

(Trailing4Quarters)

On a Per Share Basis, Free Cash Flow Has Recovered Most Dramatically

Relative to Sales, Earnings or EBITDA for the S&P 500 Index

Trailing 4 Quarter Sales, EBITDA, Earnings and Free Cash Flow per Share2nd Quarter 1998 to 4th Quarter 2010

$200

$400

$600

$800

$1,000

$1,200

Earnings per

Share

Free Cash Flow per

Share

EBITDA per

Share

Sales per

Share

Q2 1999

Q4 1999

Q2 1998

Q4 1998

Q2 2000

Q4 2000

Q2 2001

Q4 2001

Q2 2002

Q4 2002

Q2 2003

Q4 2003

Q2 2004

Q4 2004

Q2 2005

Q4 2005

Q2 2006

Q4 2006

Q2 2007

Q4 2007

Q2 2008

Q4 2008

Q2 2009

Q4 2009

Q2 2010

Q4 2010




Companies have also improved their earnings and ree cash fow by rapidly deleveraging—that is, reducing debt on their balance sheets which reduces interest expense.And at the same time, they have taken much o the ree cash fow generated and heldit on their balance sheets in the orm o liquid short-term investments (called cashand equivalents). As the chart below illustrates, cash and equivalents or the S&P 500companies as a percent o their total current liabilities was approximately 90% in theourth quarter o last year. Another way to express this is that there was $0.90 ocash and equivalents or every dollar o total current liabilities (which are short-termobligations that companies owe like vendor payables, wages due or taxes owedtypically in the coming 30 days). That is a record amount o short-term liquidity.

These same companies have rapidly reduced their debt exposure, as shown by thetrend below in net debt to book value per share. Net debt is the amount owed aterany surplus short-term assets (like cash and equivalents) are netted against thisamount. And book value per share is the total amount o shareholder equity on anaccounting basis (consisting primarily o stock issued, paid-in-capital and retainedearnings). From 1998 to late 2007, this ratio fuctuated in a range o $1.75 to $2.00,

but since the Great Recession, it has come down to approximately $1.00 per dollaro shareholder equity. One thing to keep in mind with this trend is that nancialcompanies such as banking institutions (a key part o the S&P 500) have beenresponsible or much o this drop in net debt to book value per share as they haveraised their shareholder equity with government support and substantially reducedthe leverage ratio on their lending and investing activities.

While all these trends have cheered investors, there is one area o growing rustrationlinked in part to the large amounts o cash and equivalent short-term investmentsthe combined S&P 500 companies have on their balance sheets. Investors wantcompanies to reinvest earnings in a productive way that continues to generate (or

Source: Bloomberg

Cash and Equivalents as a % of Current Liabilit

ies

Quarter/Year

R

ti

fN

tD

btt

B

kV

l

Sh

Leverage and Liquidity Have Improved Substantially for the S&P 500 Index

Net Debt to Book Value per Share (leverage) and Cash plus Equivalents as a Percent of Current Liabilities (liquidity)2nd Quarter 1998 to 4th Quarter 2010

30%

40%

50%

60%

70%

80%

90%

100%

$0.50

$0.75

$1.00

$1.25

$1.50

$1.75

$2.00

$2.25

Net Debt to Book

Value per Share

Cash plus Equivalents as a

Percent of Current Liabilities

Q2 1999

Q4 1999

Q2 1998

Q4 1998

Q2 2000

Q4 2000

Q2 2001

Q4 2001

Q2 2002

Q4 2002

Q2 2003

Q4 2003

Q2 2004

Q4 2004

Q2 2005

Q4 2005

Q2 2006

Q4 2006

Q2 2007

Q4 2007

Q2 2008

Q4 2008

Q2 2009

Q4 2009

Q2 2010

Q4 2010

Companies have also

improved their earnings

and ree cash fow by

rapidly deleveraging—that

is, reducing debt on their

balance sheets whichreduces interest expense.

And at the same time, they

have taken much o the

ree cash fow generated

and held it on their balance

sheets in the orm o liquid

short-term investments.




increase) its return on shareholder equity. And any money that can’t be productivelyreinvested in its businesses or that purpose ought to be returned to shareholderseither in the orm o dividends or share buybacks. (While acquisitions are anotheruse o excess cash, these can oten make investors nervous out o the ear thatmanagement will overpay to buy a business and hurt the company’s stock price.)

The chart below illustrates the 20-year trend or the combined S&P 500 companiesin dividend payout ratio (the percentage o earnings per share which are paid out asa dividend) and the dividend yield (a measure o total shareholder return representedby the dividend—calculated as the dividend per share paid divided by the market priceor one share o stock). The dividend payout ratio is clearly at a 20-year low. Thedividend yield is also low (slightly under 2% as o the ourth quarter) because theequity market rally since the Great Recession has driven stock prices up while manycompanies either roze or cut dividends during the recession.

With such a low dividend payout ratio, low dividend yield and large amounts o cash ontheir balance sheets, investors are challenging the management o many companies

to either dene a strategy to put these short-term unds to work or announce plansto return these unds to investors in the orm o higher dividends or share buybacks.Assuming the results or the rst quarter continue recent trends o strong earningsgrowth and rising balances o cash and equivalents on their balance sheets, expectthese kinds o demands by investors to grow louder and more widespread. This evenhas the potential to become a political issue as earnings grow but employment lags.

The opinions expressed are those of American Century Investments and are no guarantee of the future performance of any AmericanCentury Investments portfolio. This information is not intended to serve as investment advice; it is for educational purposes only.

Investors want companiesto reinvest earnings in

a productive way that

continues to generate

(or increase) its return on

shareholder equity. And

any money that can’t be

productively reinvested in its

businesses or that purpose

ought to be returned to

shareholders either in

the orm o dividends orshare buybacks.

©2011 American Century Proprietary Holdings, Inc. All rights reserved.

FLY-70889 1104

0%

10%

20%

30%

40%

50%

60%

70%

80%

Source: Bloomberg

D

ividend Yield (Trailing 4 Quarters)

Quarter/Year

Dividen

dPayoutRatio(Trailing4Quarters)

The Dividend Payout Ratio Is at a 20-Year Low for the S&P 500 Index

Trailing 4 Quarter Dividend Payout Ratio per Share and Dividend Yield per Share

2nd Quarter 1991 to 4th Quarter 2010

1%

2%

3%

4%

5%

6%

Dividend Payout

Ratio per Share

Dividend Yield per

Share

Q4 1992

Q3 1993

Q2 1991

Q1 1992

Q4 1995

Q3 1996

Q2 1994

Q1 1995

Q4 1998

Q3 1999

Q2 1997

Q1 1998

Q4 2001

Q3 2002

Q2 2000

Q1 2001

Q4 2004

Q3 2005

Q2 2003

Q1 2004

Q4 2007

Q3 2008

Q2 2006

Q1 2007

Q4 2010

Q2 2009

Q1 2010

Expectations Are High for Continued and Impressive Earnings Growth

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