Interesting note from Moody’s today, making the point that companies cannot afford indefinitely to fund increases in shareholder compensation from corporate earnings, especially if earnings are flat to lower. The demands placed on earnings by shareholder compensation can be assessed by the ratio of the sum of net equity buybacks plus net dividends to pretax profits from current production (as derived from US government data). Moody’s call this the shareholder compensation ratio.
During the year-ended Q1-2016, the sum of net equity buybacks plus net dividends approximated 96% of pretax profits from current production for US nonfinancial corporations. The latter exceeded each comparably measured yearlong ratio prior to 2007.
Moreover, net stock buybacks plus net dividends averaged a smaller 67% of profits from current production during the three previous recoveries, wherein the ratios ranged from 61% for 1983-1990’s upturn, 55% for 1991-2000’s recovery, and 80% for 2002-2007’s upswing. Ratios of 85% or higher more than three years after the end of a recession tend to indicate either the late stage of a business cycle upturn or the presence of a recession.
During the mature phase of 2002-2007’s recovery, the ratio first broke above 85% in Q4-2006. A recession materialized after the shareholder compensation ratio climbed up from Q4-2006’s 95.4% to Q4-2007’s 130.2% of profits from current production. Though the climb by the ratio hardly triggered the Great Recession, it reflected a loss of financial flexibility that left businesses less capable of absorbing the shock of unexpectedly low profits.
An elevated shareholder compensation ratio reveals a reduction in the earnings that underpin corporate credit quality. In turn, the now exceptionally high shareholder compensation ratio warns of a limited scope for any narrowing by the US high-yield bond spread.
