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Morningstar economist, Francisco Torralba, Ph.D., CFA, recently published a report that looked at corporate profits broken down between profits generated internationally versus profits generated in the U.S. This distinction is important as many strategists contend the profits to GDP ratio, or as they call it profit margins, are at a peak and unsustainable, i.e., will mean revert in the near term. The chart that is often displayed to support this view is the following one:

From The Blog of HORAN Capital Advisors

A few of the articles noting this issue of so-called peak corporate profit margins can be read below. Note the date in which the articles have been written vis-à-vis the equity market's performance.

In the Morningstar article, Dr. Torralba, Ph.D. notes the following about the profit margin graph displayed above:

"A profit margin is commonly defined as profits divided by revenues. GDP is an aggregate expenditure in the economy, which is definitely not equal to aggregate corporate revenues. It is reasonable to expect that profits as a share of GDP and profit margins are correlated but they are not the same thing. A meaningful ratio would instead divide profits, which is the income of corporations, by total income in the economy. This new ratio I interpret as the share of total income that goes to corporations: not the profit margin, but the profit share."

"My second point is that the number in the numerator of the "profit margin" on the chart above comes from national income figures. It includes profits generated by corporations with legal residence in the U.S., regardless of whether those profits came from U.S. operations or foreign operations. This measure of profit includes income earned by Amazon in the United Kingdom, and excludes income earned in the U.S. by Toshiba. GDP, on the other hand, captures economic activity within U.S. borders, whether it is done by U.S. companies or foreign companies, and excludes activity by U.S. companies abroad. It is misleading to compare these two magnitudes: worldwide profits of U.S. corporations and GDP generated within U.S. borders."

Torralba corrects for this difference between U.S. and international profits by analyzing data from the Federal Reserve's Flow of Funds tables that does disaggregate profits that are generated domestically and those generated outside the U.S. The first chart below shows the result of this analysis. The second chart shows a projection of the trend in the first chart. His conclusion:

"To be more specific, I have estimated the trend of my two time series, foreign and domestic, of the profit share. As of 2008, the last year for which I estimate the trend, the "normal" (i.e. trend) profit share was 12.5%. If it had continued rising at the same pace as it did in 1988-2008, as of 2012 the "normal" profit share would be 13.2%. The actual profit share was 14.4%: still too high, but by 9%, not by 70% as Hussman says (last chart below)."

From The Blog of HORAN Capital Advisors

From The Blog of HORAN Capital Advisors

The conclusion of Torralba's report certainly notes corporate profits cannot grow forever. He validly notes that segmenting profits generated domestically versus those international are important, especially due to the improving economic picture in Europe, or at least not appearing to be worsening.

Source:Viewpoint on Corporate Profits

Source: Corporate Profit Margins Not At A Peak