A trader in London waits for European stock markets to open early on June 24, 2016, after Britain voted to leave the European Union. REUTERS/Russell BoyceLONDON, April 14 - Economic theory today is far removed from what happens in the real world. Its canonical models portray the corporate sector as a single representative firm that acts in the interests of its owners. Anyone who has worked in finance knows these models are contrived.
Instead, managers prefer to take on debt to buy back shares at inflated prices. Finance theory suggests that a company’s valuation should not change whether it is financed with equity or debt. In reality, debt-financed buybacks serve to boost share prices, says Smithers. He also observes that companies seek to maintain a stable ratio of interest payments to profits. Thus, as long-term interest rates have declined, U.S. companies have taken on more and more debt to repurchase their shares.
Because Tobin’s Q is not a practical valuation tool, most investors prefer to compare earnings yields – a company’s earnings per share divided by its share price – with bond yields. In recent years, as bond yields fell to their lowest level in history, the valuation of U.S. stocks has soared. But Smithers maintains that comparing the two makes little sense. After all, stocks are claims on real assets whereas bonds represent paper claims.
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