Earnings not always a reliable measure
You may think that cutting company tax rates in the US from 35% to 21% would boost taxed earnings. But not so fast. While the longer-run effect of lower taxes will clearly benefit shareholders, the immediate effect of a lower tax rate can significantly reduce, rather than improve, the bottom line. This is the case with some of the very large US banks that reporting or about to report their latest results.
Citibank, for example, will be making enough of a tax charge to its earnings — as much as $22bn — for the bank to post a loss for its 2017 financial year.
Some of the other major US banks, including JPMorgan, will be deducting large sums (in its case $2.4bn) as a once-off adjustment for lower tax rates to come. Wells Fargo, by contrast, was able to add $3.35bn to its earnings, as did another large bank, PNC.
The banks and companies that are able to immediately boost earnings have net deferred tax liabilities — about $2.37bn worth in the case of PNC. These provisions against future tax liabilities had been deducted from earnings.
Now, with lower tax rates, this reserve can be reduced and added back to earnings.
JPMorgan and Citibank, by contrast, have accumulated tax assets rather than liabilities. Such potential benefits will have boosted earnings over the years. At a lower tax rate, these assets are worth less and so have to be written off current earnings.
These important recent developments on the earnings front raise the issue about the usefulness for investors or operating managers of these heavily and frequently adjusted bottom line earnings. Quarterly reported earnings cannot be regarded as a reliable measure of the long-run potential of the companies reporting. Nor, since the definition of earnings has changed so much over the years, can these reported earnings be helpfully compared with earnings in the distant past.
But there is one measure of the performance of a company or of a stock market that has the same meaning and significance today that it had 50 years ago. That is the cash paid out to shareholders as dividends. Companies do not easily pay away real cash unless they are confident they can maintain such payments.
As such, their dividend payments constitute a very real measure of the expected earnings that help determine share prices. A comparison between S&P 500 index earnings and dividends makes the point. Dividend flows are far smoother than earnings, smooth enough to be regarded statistically and for economic reasons as a normalised measure of earnings.
US share prices since the crisis of 2008 are in fact much better explained by the flow of dividends than the flow of earnings. Dividend payments by S&P companies grew steadily from 2014 to 2016, even as earnings fell away sharply in 2014. This helped to support further improving share prices.
S&P index dividends moreover have continued their steady advance even as earnings have rebounded. Dividends since 2012 — a period when the S&P index gained an average 13% a year — have risen on average 10.5% a year, while earnings grew 3.5% a year average, with twice as much volatility. It would appear that investors who were bidding up share prices were taking more notice of dividends than actual earnings.
The quite stable dividend yield on the S&P 500 is very much in line with its post-2000 average. This does not appear to indicate an overvalued market, especially when this dividend yield is compared with interest income, which is the alternative to dividends.
And lower tax rates will surely encourage US businesses to raise their dividend payments.