Debunking S&P 500 Profit Margin Anxiety

 |  Includes: SPY
by: Simon Moore, CFA

There is a train of thought that S&P 500 SPY net profit margins are at a very high level by historical standards and therefore the index isn't as cheap as it seems because these margins will likely mean revert in the near future.

I'd like to use this article to debunk the timing on that argument, because though margins are unquestionably high by historical standards, the macroeconomic factors that impact corporate profit margins (interest rates, the tax code and unemployment) are slow moving and highly unlikely to change materially even on an 18 month view.

Where Are Corporate Profit Margins By Historical Standard?
First off, here is the data, it certainly is true that the net profit margin is high relative to ~12 years of history. With Q3 running at 8.5% net margin vs. 6.2% average for the period, and it's a fair bet Q4 will be higher even though not all the data is in yet.

(Click charts to enlarge)

S&P 500 Net Income Margin 2000-2011

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However, that's only recent history; we can zoom out further if we use government data. Note this is NIPA data so economy-wide and certainly not apples-to-apples with the S&P 500 in terms of coverage or methodology and academics have written detailed papers on this question, which I'll spare you the details of. Nonetheless we see a broadly similar picture, and even the past 10 years start to look like an anomaly.

Corporate Profits As % Of GDP Based On Government Accounts

So, what's driving this pretty substantial change? Well a few factors are at play, and clearly this is zero-sum. If more is arriving at the bottom of the income statement as profits, then others claimants on the firm's revenues (e.g. employees, debt holders or the IRS) must be getting less.

Employees Are Getting Relatively Less

It turns out that employees are getting paid less as a percentage of sales than previously. Not a post-war low if you look at the 1950s for context, but if margins have risen from about 4% in the 1980s to closer to 10% now, then falling wages (as a % of sales) have accounted for about +1.5% of that, or about a quarter.

Employee Wages As % Of GDP

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And The Tax Rate Has Declined Substantially Too
Anyone who has been paying even some attention to politics to the past decade, shouldn't be surprised to learn per the chart below, that tax rates as a percentage of corporate profits have fallen, from about 30% in the 1980s to closer to 20% today. Here the math on what this does for corporate profits gets a little non-intuitive, but the result is roughly a 13% increase in profits. So if profits rose +1.5% because of lower wages, then lower taxes adds another +1%.

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Lower Interest Expense Makes A Big Difference
The market average debt/(debt+equity) is 32% and the P/S for the market is about 1.3x. Therefore, for the average company in the S&P 500 debt is about 75% of annual sales. Assuming a constant spread for the risk of corporate debt, the reduction in interest rates has been from about 8% in the 1980s to 2% today, that 6% decline is worth about 4.5% to corporate profits.

(As an aside I should point out that the decline in interest expense isn't a free lunch, it reflects lower inflation and therefore lower growth in earnings, hence although margins are higher as a result of this, the multiple paid for those earnings should theoretically decline because of lower nominal growth i.e. lower inflation)


Factor Contribution To Corporate Profits Since 1980s
1 - Lower Cost Of Debt +4.5%
3- Falling Wages +1.5%
3- Lower Taxes +1%
Total As Calculated +7%
Actual Historical Result +6%
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This back of the envelope math gets us to a slightly larger boost to corporate profits than has actually occurred, and I may have overlooked additional contributing or inhibiting factors. Nonetheless, it helps us understand and quantify what is driving the rise in profits at a broad level even if we should be careful about ascribing statistical significance to the numbers in the above table.

The rise in corporate profits can be more than accounted for by lower wages, taxes and lower cost of debt. None of these are likely to change in the near term. With unemployment over 8% wage growth should remain subdued, interest rates fell in 2011 and the U.S. tax system is unlikely to change before 2013 given the current political environment.

Therefore, investors should not worry about 'record' profit margins for now, certainly it is a negative for the medium term and another reason to keep a close eye on Treasury yields, but without signs of increasing interest rates in particular, corporate profits should remain at high levels for the next 18 months at least.

Those who call for the S&P 500 to decline based on declining profit margins in the near term, are failing to assess the long-term nature of the primary factors that drive profit margins at the macroeconomic level.

Final Thought - The Mix Effect
Another important factor is the mix of industries and their weights in the S&P 500. For example, Apple AAPL is now the largest company in the S&P 500 with a 4% weight, not so long ago its weight was closer to 1%. Apple has a 25% margin, vs. the 8.2% S&P average. Therefore Apple alone has increased the S&P 500's net profit margin +0.5% as its weight in the index has increased 4x at over 3x the average margin of the index. This may also be true at the broader economic level as the U.S. moves from commodity industries to value added services, which are generally higher margin.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.