The Future of Corporate Profits. The "E" in the P/E Equation
I wrote this article last year, on the risk that high corporate margins present to investors. Here is updated excerpt from that article:
Today’s stock market valuation is higher than it may appear. As margins revert to the historical average (and they always do), corporate earnings growth will either decelerate — disappointing Wall Street expectations of 8% earnings growth (according to First Call) for the S&P 500 over next five years — or decline, driving earnings, the “E” in the P/E equation, down. The broad market index fund investor may be in a pickle when a cheap market suddenly becomes more expensive. If today’s corporate profitability reverts to the mean profit margins observed over the last 25 years (8.8%), corporate profits would decline almost 31%.
This chart speaks a 1000 words:
Grantham is a fine researcher, but perhaps he overlooks the significance of the major structural change in the world economy – the tremendous increase in the supply of labor. Labor is the primary input, and this supply increase will dampen labor costs for another two decades. We may thus expect profit margins not to revert for a very long time.
Jay Z,
Lower labor costs will be available to all companies large and small. Though in a short-run (the last couple years) companies get to keep the costs savings that come from lower labor costs. However, in the long run the high margins and thus above average return on capital will attract new competition which will force companies to lower prices or spend more money on differentiation.
Companies that have strong competitive advantage will be impacted less by inroads of new competitors and thus may get to keep their margins for a longer period of time.
-Vitaliy
Agreed high profit margins may revert, hurting stock indexes.
I wonder if Corporate American earnings can really be compared to American GDP. Many American corporations earn substantial profits outside the U.S. Is this possibly part of the reason for the apparent rise in margins?
Could we get a world profits divided by world GDP and see if that margin is trending up?
Vitaliy writes that “”in the long run high margins and thus above average return on capital will attract new competition which will force companies to lover prices…”
This is a well known and accepted argument, but it applies to specific industries with above average profitability – not to the economy as a whole. New competition requires capital, and since economy-wide margins and profitability is higher, no new capital will flow into any industry. Another way to see this is by asking, Where would the capital come from?