There are many notable investors these days saying that the market is overvalued. Jeremy Grantham, for one, has been pessimistic in his assessment about current market levels. Their reasoning is based on corporate profit margins being at all-time highs while valuation levels continue to climb higher. This article seeks to shed light on some of these issues and provide something of a glide path for understanding how profitability might evolve in the next few years.
In a previous article, we identified two factors that are affecting profitability levels: the negotiating power of companies in the labor market and the lower interest expense. The first has been caused by the weak labor market and shows up as a declining COGS expense as a percentage of sales. The second obviously is driven by low interest rates and is reflected below the operating profit line. The following chart is an updated version of the one that appeared in the previous article and shows the continuing trend of declining COGS and interest expense percentages.
The main goal of this article is to provide some perspective on how margins and valuation will play out in the coming years. If corporate profits, as a percentage of GDP, are at an all-time high, to what level and when will these margins revert? How will this affect valuation? Will there be enough top revenue/GDP growth to offset compressing margins? These are the questions that we are trying to answer.
Interest Rates: Related to both Cash Flows and Pricing
The interest rate creates a two-pronged spear. A company's interest expense, driven by interest rates, is an actual cash flow that affects company profitability. The interest rate also goes into calculating a company's cost of capital which is necessary to price the asset. Both affect valuation: one determines the ultimate cash flow to discount and the other determines the actual discount rate.
We estimate that the average interest rate paid in our sample of companies from the chart above is 3.97%, let's call it 4.00%. We also estimate an average tax rate of 28% for these companies.
To start with the asset pricing portion, we need to deduce what type of growth the market is currently pricing and then figure out how a changing discount rate will affect prices. We will use a 100 bps shock as an illustration. Even though there might not be an immediate increase of 1% of interest rates, this could represent the movement of the rate over a few quarters' time. The current 10-year rate is 2.75%, and we estimate a market risk premium of 6.50%. The market itself has a beta of 1.0 by definition, so therefore the cost of capital for the market is 2.75%+6.50%=9.25%. The current S&P 500 P/E ratio is 19.80.
The Gordon Growth equation is Price=DividendX (1+growth rate)/(cost of capital - growth rate). The P/E in this equation is the Price/Dividend. If you know the cost of capital and the P/E, then you can back out the constant growth rate. In the present market based on the P/E of 19.80 and the cost of capital of 9.25%, we estimate a constant growth rate of 3.99%. If you shock the cost of capital by 100bps to 10.25%, then the estimated constant growth rate that would be embedded in market pricing would be 4.95%. Keep in mind that inflation is likely to be about 2% over time, and the US economy is currently barely growing in real terms. In that regard, these numbers might look a little high.
The Gordon Growth model is used to deduce the growth rate; that growth rate is the constant growth rate every year from now until forever. Sometimes it might be helpful to break the valuation into two valuation periods: a "forever" or terminal period and a period for the next decade or so. For this terminal period, we use a growth rate of 2.0%, or the inflation rate, and conservatively do not predict any real growth during this period. In this example, our terminal period will start after 15 years from now. If the terminal growth rate is expected to be 2%, we therefore need to deduce the growth rate from now until the terminal period to make the current valuation work. By using this method, we back into a years 0-15 growth rate of 11.75% for the 9.25% cost of capital and a 13.75% growth rate using the shocked discount rate.
The higher the discount rate, the higher the growth rate needed to justify the current market valuation. In our current situation, we regard the growth rates built into market pricing as being on the high side of fair value. The market is not in bubble territory, however we are not at the bargain basement of market pricing either.
Finally, we look at what the P/E should be using the shocked cost of capital but using the existing embedded growth rate as determined above. The current market P/E is 19.80, and we estimated the cost of capital to be 9.25%, which gave rise to a built-in constant growth rate expectation of 3.99% per year. In terms of asset pricing, if we believed that the growth rate was still 3.99%, yet we used the shocked discount rate of 10.25% instead of 9.25%, then we would price a P/E = (1+.0399)/(.1025-.0399)=16.63. Therefore, the market would need to adjust from 19.80 to 16.63, which would represent a return of -16.0%. This return is based purely on the asset pricing effect of using a larger discount rate to discount future cash flows and has nothing to do with the fundamentals of the underlying business.
A secondary issue involving interest rates is that the interest rate does have an effect on the fundamental cash flow of the business by increasing the interest cost of servicing the debt.
We estimate that the average borrowing cost of companies in our sample above was about 4.00%, and the average tax rate is 28%. A shock of 100bps would mean that the interest rate on debt service was now 5.00%. (Of course this is simplistic but also useful for the sake of thinking about how changes in interest rates will affect profitability. Some debt is fixed at previous rates, and there may not be a parallel shift in corporate debt spreads.) Based on the tax rate (interest is deductible) and the higher interest rate, we estimate that a 100bps shock would cut into profitability, per the chart above, by about .40% of sales. This is not a large number relative to the current average net margin of about 13.9% of sales. In this case, we might expect the E in the PE to decline by -.40/13.9=-2.9%; this is not hugely significant, but not a positive development either.
Negotiating Power in the Labor Market
The interest rate shock can be modeled somewhat reliably per the above analysis, but the labor market's effect on corporate income statements is somewhat elusive. Most people have thought that the recession would not last this long. The recovery that we are having is not particularly strong, and the labor market is still very weak. The unemployment rate is still above the natural rate of employment and the participation rate is low, which may be understating the true unemployment rate. This lethargy has given rise to speculation of even a secular stagnation. Add to this other secular business trends, such as outsourcing American jobs and the rise of emerging market companies being more competitive globally, and it is very hard to predict how the US labor market improving will affect corporate profitability.
We can say one thing though: competition happens. This relates both in labor markets with the competition for talent and amongst companies with the competition for profits.
We can say that companies, at these high profit margins, are earning in excess of their cost of capital. This invites competition, which whittles down these high profitability levels. As for workers, the labor market is improving. Eventually, it will be easier for overworked workers to change jobs; this will force companies to either bring in more help or pay these workers more money. Either way, margins compress.
To put this situation into perceptive, the average COGS percentage, where direct labor expense is recorded, is 49.0% (percentage of sales) today. The previous decade's average was 52.9%. Today's number is almost a full 4.0% less than the decade's average. 4.0% out of the operating margin of 23.9% represents a full 16.7% of total operating profits. Getting back to average COGS levels would cut into the operating margin significantly. If the COGS percentage reverted back to just the average level from the last decade, we would expect the E in the P/E to decline by at least -16.7%.
In this article, we tried to quantify the effect of an increasing interest rate and an improving labor market on corporate profits and, in turn, on corporate valuations. Although there were many numbers and formulas used, the basic idea is that an improving labor market and rising interest rates will have a negative effect on corporate valuation. It is hard to judge when this will happen and if top line revenue growth can help to offset some of these declines. A rising interest rate leads to higher costing debt, which causes a decline in overall corporate profitability. Further, higher interest rates affect asset markets in that they lead to higher discount rates, which is like gravity on share prices.
Although we are not as pessimistic as the likes of a Jeremy Grantham, we are still cautious and vigilant towards the future as to how the situation will unfold. We believe that stocks are on the high side of fair value at this point but not into bubble territory yet.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.