Market gurus like Deutsche Bank’s David Bianco and Jesse Livermore of the Philosophical Economics blog continue to defend their theses that corporate profit margins are sustainable at higher-than-historical levels.
The sustainability of these margins is one of the hottest debates among stock market watchers today, with the bears predicting that margins will contract sharply. They argue that contracting margins will mean collapsing profits and ultimately tumbling stock prices.
But in an unexpected twist, Bianco and Livermore independently pivoted the debate in the same direction. Both argue that we should be considering profits relative to capital (e.g. return on equity (ROE) or return on assets (ROA)), not profit margins (that is, profits as a percentage of sales). After all, return on capital is the primary metric a business considers before making an investment.
“Profits of GDP and net margins are incomplete profit metrics,” said Bianco in a research note on Friday. “Profits should be measured relative to capital employed and both NIPA based ROA and S&P financial statement based ROE measures are consistent with history.”
“The mistake we’re making here is to assume that corporations “compete” for profit margins,” wrote Livermore on Sunday. “They don’t. Profit margins have no value at all. What has value is a return. The decision to expand into the market of a competitor and seek additional return is not a decision driven by the expected profit margin, the expected return relative to the anticipated quantity of sales. Rather, it’s a decision driven instead by the expected ROE, the expected return relative to the amount of capital that will have to be invested, put at risk, in order to earn it.”
ROE and profit margins aren’t mutually exclusive. In theory, the profit margin is just one of several variables that drive ROE; other variables include asset turnover, leverage, borrowing costs, and tax rates. In theory, a shrinking operating profit margin can be offset by a combination of higher asset turnover, lower borrowing costs, higher leverage, or lower taxes.
“The right metric to focus on, the metric that actually mean-reverts in theory and in practice, is return on equity (ROE),” emphasised Livermore. “Right now, the return on equity of the U.S. corporate sector is not as elevated as the profit margin, a fact that has significant implications for debates about the appropriateness of the U.S. stock market’s current valuation.”
Bianco provided a series of charts including the one below. As you can see, ROE isn’t at an unreasonable level.
This chart also shows the growing capital depth of the U.S. economy. “The higher share of S&P profits as % of GDP is supported by higher S&P equity book value as % of GDP,” said Bianco.
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