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Profit margins are falling.

When I checked last Friday, sales per share for the S&P 500 was $940.90 while earnings per share was $80.39, giving the market a profit margin of 8.5%.

Since Q4 1986, the profit margin of the S&P 500 has averaged 5.8%. At this level of profitability, earnings on the S&P 500 would be $54.57, and the market would be trading at 27.3x earnings. The profit margin when using operating earnings (excluding charges) has averaged 6.6%. Using this level of profitability, earnings would be $62.10, and the market would be trading at 24.0x earnings. If margins were to fall to 7.0%, the market would be trading at 22.6x earnings. At a 7.5% margin, the valuation would be 21.1x.

Profits are declining. Trailing 12 month cumulative earnings per share for the S&P 500 was $85.19 on November 2, down almost $5 in a month.

One of the bulls' arguments is that markets are cheap. Current 2008 operating estimates are $102.78. At those estimates, the market is trading at 14.5x earnings. Operating estimates for 2007 are $91.75. Therefore, the market is expecting a 12% increase in profits next year. Historically profits have grown 6% over time. Thus, market expectations are enormously heroic, given the economic slowdown (or recession) and declining profit margins. Also, expectations are falling. Estimated 2007 operating earnings per share for the S&P 500 was $95.42 on August 17. Besides, using operating profits instead of reported profits to value the market is flawed, a subject I will tackle in the near future.

If profit margins continue to fall, as I expect they will given that cash flow has been falling while profits have been rising, then the market is not as cheap as it might appear.

Source: What Do Falling Profit Margins Say About the Market?