Wednesday, July 5, 2017

US Corporate Finance: Show Me the Money

S&P 500 operating earnings totaled $958 billion over the past four quarters through Q1-2017, with buybacks and dividends accounting for 95% of this total. The dividend payout ratio of the S&P 500 remains around 50%. This implies that corporations are spending all their extra cash on buybacks rather than capital spending and wages.

The problem with this widely circulated myth is that profits are not the same as cash flow. The latter is equal to retained earnings (i.e., after-tax profits less dividends) plus the depreciation allowance. When we add the cash flow plus net bond issuance of nonfinancial corporations (NFCs), the resulting series is more often than not very close to capital expenditures plus buybacks. Here are a few round numbers for 2016 based on data compiled in the Fed’s Financial Accounts of the United States (Table F.103):

(1) Sources of cash. NFCs had reported pre-tax profits of $1,271 billion. They paid $322 billion in taxes and $617 billion in dividends. They had $1,307 billion in capital consumption allowances (CCA). Their internal cash flow, i.e., the sum of their retained earnings and CCA, was $1,639 billion. Their net bond issuance was $268 billion. These sources of cash sum to $1,907 billion.

(2) Uses of cash. Capital expenditures (including inventory investment) totaled $1,670 billion last year. Buybacks totaled $586 billion. These two categories of spending sum to $2,256 billion.

The discrepancy between the sources and uses of cash seems large, but it tends to average out over time. Besides, the analysis above excludes lots of other items in the Fed’s accounting for this sector. The main point is that cash flow is much bigger than after-tax profits less dividends. Companies have been spending plenty on capex, including on technology, which is cheaper and more powerful than ever.

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