SovereignInvestor wrote: ↑Sun Apr 14, 2019 9:46 pm

1) Say there's no inflation ever and gross earnings never grow. If EPS was 1.00 every year from 2009-2018 and then the S&p buys back 50% of shares before at end of 2018, then the EPS becomes say 2.000 for 2019.

The true nominal gross earnings for SPX say never changes but because 50% share reduction into 2018, it becomes 2.00 going forward instead of 1, then CAPE will give huge divergence from reality.

Hmmm .... interesting. Immediate reaction is that I don't think a company can artificially reduce the "E" without increasing the "P" by the same amount-- which results in the P/E staying the same. Here is my argument:

Let's consider 3 example companies with simple numbers. The only difference will be dividends vs. share buybacks vs. earnings reinvestment.

Company A, B, and C all start with 100 shares and a total market cap of $1,000. (So, share price is $10 per share.) All 3 companies produce $100 in total annual earnings. (So, earnings is $1 per share.)

However, company A pays out its earnings as a dividend, company B buys back shares, and company C reinvests the earnings in its business with an internal rate of return of 10%.

Here's what happens to the companies over a 3 year period:

Company A pays dividends:

- Year 1 -- Pays $1 per share dividend. Per share price and per share earnings stays the same.

- Year 2 -- Pays $1 per share dividend. Again, per share price and earnings stay the same.

- Year 3 -- Pays $1 per share dividend. Final share price = $10, final per share earnings = $1, final P/E = 10.

Company B buys back shares:

- Year 1 -- Buys back $100 worth of shares, or 10 shares. The share count is now 90, but the market cap of the company needs to stay constant (the total market cap can't magically jump just because the company bought back shares)... this results in a price increase per share. Share price goes to $1000/90=$11.11. Earnings per share is now $100/90=$1.11. P/E = 10.

- Year 2 -- Buys back another $100 worth of shares, or 9 shares. Share count goes down to 81. Share price goes up to $1000/81=$12.34. Earnings per share goes up to $1.23. P/E = 10.

- Year 3 -- Buys back $100 or 8.1 shares. Share count goes to 72.9. Share price = $13.72. Share earnings = $1.37. P/E = 10.

..... So, in this example, the "E" goes up artificially which causes the "P" to go down by the same amount. This is the only way for the market cap and total earnings of the company stay the same.

Company C reinvests internally at 10% IRR:

- Year 1 -- Retains and reinvests $100 earnings at 10% IRR so the total earnings power of the company is now increased to $110 annually. Price therefore also increases 10%. Share count stays constant at 100. Share price = $11. Share earnings = $1.10. P/E = 10.

- Year 2 -- Reinvests $110 earnings resulting in new total earnings rate of $121 annually. Share price = $12.10. Share earnings = $1.21. P/E = 10.

- Year 3 -- Reinvests $121 earnings resulting in new total earnings rate of $132 annually. Share price = $13.20. Share earnings = $1.32. P/E = 10.

So .......... bottom line ............ I conclude from this analysis that it makes no different to net P/E ratios whether companies distribute their earnings as dividends, buy back shares, or retain their earnings and reinvest them internally in the business.

Does that make sense?