Can Profit Margins Keep Climbing? (And What Does It Mean If They Do?)

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Sep 24, 2014 2:14:00 PM

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profit marginsHow much money companies make—their earnings—is a key factor in analyzing how expensive the stock market is. Depending on what you expect earnings to do in the future, you might decide that the market is either:

  1. Very expensive (my own conclusion, based on longer-term valuation measures), or
  2. Quite reasonable, if you assume current earnings trends are stable and likely to accelerate.

Earnings, though, depend on two things: how much companies make in sales, and how much of that they can actually keep, after expenses. Over the past several years, even as revenues have grown relatively slowly, companies have managed to cut expenses and grow earnings much faster than revenue. Other factors, such as share buybacks, are at play as well, but cost-cutting is a key driver of recent earnings growth.

As a result of lower expenses, the amount companies can keep—their profits—is at or close to all-time highs as a percentage of their sales. This number is known as the profit margin.

I’ve explained before why I expect profit margins to decline at some point, but today I want to get a bit more fundamental. If profit margins don’t decline, the American capitalist system is broken. It really is that simple.

Market capitalism should push margins back down

Think about how capitalism is supposed to work. A company does something and makes money. If it makes too much money, competition arises and enters the market, forcing prices—and profits—down. If competition doesn't arise, for whatever reason, companies can indeed continue to post outsize profit margins, and this is called a monopoly. Monopoly profits are always higher than they are in competitive markets.

Looking at the following chart from Yardeni Research, we see that current profit margins are at or close to their highest levels in the post-World War II period. Presumably, during this time frame, some force was at work to push margins back down once they rose above a certain level. I would argue that the force in question was market capitalism.

profit_margin_1

As of right now, that force seems like it may have started operating, as evidenced by a decline in margins over the past couple of quarters. If so, margins should continue on their way down, and stock market valuations will look even richer (in my opinion) than they already do. If not, and margins head back up again, we have to ask:

  • Where is the competition for the companies that are making all of this money?
  • Are we pricing in monopoly power?
  • And why should these companies have sustainable monopolies?

Another way to look at it is to consider the corporate profit total as a share of the overall economy, per the following chart, also from Yardeni Research.

profit_margin_2

Again, you can see that corporate profits are at or close to all-time highs, both as a percentage of national income and as a percentage of the economy. In these figures, companies don’t compete against each other, but against the workforce. Clearly, companies are winning the battle, but for profits to continue to rise as fast as expected, that share has to keep growing.

And let's not overlook potential government intervention

In the past, when monopolies emerged, the government has broken them up. (Think AT&T and Standard Oil.) At some point, it seems reasonable that the government will step in again; in fact, that may already be happening.

If you assume profit margins will continue to rise indefinitely, you’re essentially betting that competition won’t enter the market, and that the government will continue to stand aside as companies capture more of the economy. That may happen, but history suggests it’s a bad bet, and recent trends indicate that the reversion may already have begun.

Just something to keep in mind when trying to figure out how much money you’re going to make in the stock market . . .

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