Earnings per share get pumped up by unprecedented stock buybacks

NEW YORK » The companies in the Standard & Poor's 500 index have reported 16 straight quarters of double-digit earnings growth. If upcoming reports show that this spectacular growth continued in the second quarter, earnings per share may be pushed into double digits not because of stellar performance, but thanks to share buybacks and higher interest rates.

Share buybacks have become a big-money endeavor. The cash-laden companies in the S&P 500 spent 45 percent of their capital expenditures on stock buybacks last year, which was especially significant because capital expenditures were on the upswing. Thanks to buybacks, the S&P 500 companies now hold 10 percent of their market value in company-owned stock, according to Howard Silverblatt, senior index analyst at S&P.

Companies have never bought back this much stock before, Silverblatt said.

Exxon Mobil Corp. has bought back its own shares 22 quarters in a row. Media company Tribune Co. at the end of June repurchased 15 percent of its outstanding shares. Sunoco Inc. approved $500 million in buybacks in early July. Retailer Limited Brands Inc. approved $100 million in buybacks at the end of June; it has already spent $70 million on buybacks under a previous $100 million plan.

The shares don't disappear when a company buys them back; they just sit in the company's treasury. But when a company computes its earnings per share, those repurchased shares aren't counted. Removing them from the earnings per share calculation can make the figure look much better than it would have otherwise.

Within the S&P 500, earnings per share at 108 companies increased by at least 4 percentage points thanks to buybacks, according to S&P.

Exxon Mobil, for instance, made headlines with its $8.4 billion first-quarter earnings. The company's earnings per share rose 12.3 percent.

But without buybacks, earnings for the quarter were only 6.9 percent higher, according to S&P.

"Companies are buying back so much stock that you don't even need a strong sales performance to get these double-digit EPS (earnings per share) any more," David Rosenberg, North American Economist at Merrill Lynch & Co., wrote in a recent note.

Once a company has bought back shares, it can cancel them, which is rare. It can reissue them, or it can use them for mergers and acquisitions, which Silverblatt feels is the most likely scenario for the shares that have been bought back.

Buybacks aren't the only factor goosing earnings; higher interest rates are also helping. The S&P 500 companies have an eye-popping $631 billion in cash. Their interest income on that cash increased 34 percent last year. This year S&P expects it to rise 60 percent.

S&P expects the earnings for the S&P 500 to increase 11.1 percent this year. Of that, 1.3 percent is expected to come from the companies' increase in cash income thanks to higher interest rates.

With higher rates and buybacks helping earnings per share, companies look cheaper than they are. Earnings per share are used to calculate a company's price-to-earnings ratio, the most commonly used measure of whether a stock is fairly valued.

The average price-to-earnings ratio for the S&P 500, with companies that lose money and companies with unusually high price-to-earnings excluded, was 18.4. That's with the help of high interest payments. Exclude the interest income, and their price-to-earnings ratios look more expensive, at 20.4, according to Silverblatt.

The big difficulty, Silverblatt said, is that investors aren't used to factoring in either buybacks or huge interest earnings when they evaluate how a company is doing.

"If the interest income dries up, or the shares get reissued, or they don't buy back more, you're going to notice it right away," he said.