Wednesday, August 2, 2017

Corporate profits over time

The other day, Tyler Cowen reminded us of an old post at Philosophical Economics about corporate profits.  The post makes a lot of good points about the ways that corporate profits are mis-identified in general discourse.  For instance, comparing total corporate profits, which includes a large amount of foreign profit, to GDP is just a fairly meaningless measurement.  (It's even worse to compare stock indexes to GDP, since stock indexes as a measure of corporate value over time have a significant amount of drift over time.  They just don't work as an aggregate value measure in this way.  A distressing number of people who should know better make this mistake.)

But, I think Philosophical Economics doesn't quite take it far enough.  He limits his measurement to profits after tax.  This still leaves the issue of leverage and debt expenses.  Changing interest rates and leverage levels create arbitrary changes in profit margins over time.  The better measure to use is operating profits.  Net Operating Profits After Tax (NOPAT) is an estimate of after tax profits before interest expenses.  This provides a measure of profits for the entire liability/equity side of the balance sheet.

I realized that Philosphical Economics used data from BEA table 1.14, and that I could use that table to estimate corporate profit in a way I hadn't before.  According to this measure, profit margins appear to have had a stationary mean until the financial crisis.  After that, they increased to levels similar to the 1960s, and have since declined back down to the more typical long term range.  (See addendum below.)

This is based on profits relative to revenues.  Profits, on the other hand, have risen compared to book values.  I think that is largely do to the capitalization of human capital, which does not appear on the balance sheet, through stock-based compensation and, of course, the housing problem.  High margin business are frequently located frontier sectors in the Closed Access cities, where limited housing serves as an obstacle to competition.  That obstacle is funded through rising rents, which are paid through higher wages.  So, the book value of those firms is understated, because the houses that serve as an asset base that protects them from competition don't appear on the firms' balance sheets.

Today, competitive advantage hinges on high skilled workers in ways that continue to be reflected in revenues, but not in physical corporate assets. So operating profits are normal relative to revenues and market values but high relative to book values.

Actually, there appears to have been a bit of a secular decline in profits/market value.  (Basically the inverse of Price/Equity, which has been running slightly high.)  I don't think it's as low as it is frequently made out to be, and I think these things tend to have some structural causes as opposed to reflecting the perma-bubble that seems to capture so much of the public imagination.  One reason I think P/Es might be slightly high is lower corporate leverage on an enterprise value basis.  I wonder if this human capital issue I another.  That human capital tends to be paid in stock options more than labor used to be.  Shareholders basically are selling calls on their firms.  It's insurance that has already been expensed doubly, in a way, both through an estimate of the value of the options, and through share dilution.  That lowers equity risk going forward, both on the upside and on the downside.  Depending on how that trickles through valuations, that could boost P/Es I think.  After all, in the Black-Scholes model, call sellers are willing to basically earn the risk free rate. Right? That's a high P/E.

Addendum:
I suppose if I'm going to be pedantic, I should be more careful about my data.  I think I mixed up non-financial and financial profits and value added a little bit in the graph above.  Here are graphs for both (1) domestic non-financial NOPAT and profit compared to non-financial corporate value added, and (2) domestic total corporate NOPAT and profit compared to total corporate value added.

The basic story remains the same.  By accounting for corporate operating profits that accrue to creditors, long term margins are much more stable.  Most of the supposed recent growth in profits is simply due to a reversion back to normal levels from the late 1970s and 1980s when leverage was higher on an enterprise value basis and a significant amount of interest expense was simply an inflation premium that doesn't get accounted for easily in national accounts.

Operating profits remain fairly stable through the Great Recession.  But, making these corrections, the recent boost in margins does move slightly above the peaks we saw in the 1960s - slightly higher relative to those levels than my original graph.  In both cases, margins have moved back to the top end of the long term range.

4 comments:

  1. OT

    ...prices have reached a "worrying state," and it has now become urgent to tackle the housing shortage, Hong Kong Chief Executive Carrie Lam Cheng Yuet-ngor says.

    Despite increased housing supply, the government's property price index rose 9.3 percent in the first half of 2017, while the prices of private properties have climbed for the past 15 months, Lam said yesterday.

    "In reality, the rise in income cannot catch up with the rise in property prices, so the difficulty in purchasing flats is an issue we have to address immediately," she said.

    She added that Hong Kong families were spending on average 66.1 percent of household income to pay mortgages in the first quarter, as reflected by the latest Median Mortgage Payment and Loan Repayment to Income Ratio.

    --30--

    http://www.thestandard.com.hk/section-news.php?id=185879&sid=4

    Not sure what this means. It looks to me like residents of global cities are spending more of their income on rents. They may have somewhat higher pay, but that is more than eaten up by rents/mortgages.

    Hong Kongers spend 66% of income on mortgages? Egads.

    Hong Kong runs large trade deficits.

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  2. Why aren't interest rates and profit rates connected?

    What is the difference between $1 in direct ownership of an assets vs $1 in debt secured by the exact same asset? If the asset becomes worthless, the capitalist who provided the capital losses his $1 in both cases. The only difference is who loses their money first if the asset only partially becomes worthless.

    But the firms with the highest profits often structure their investments in ways that ensure lenders face higher risk of loss than shareholders - thus share holders face lower risk but are rewarded at 10% while lenders get 4% for the bigger risk.

    Before the 30s, lenders seldom provided more than 50% of the cost of assets with the owners required to come up with 50%, except for mostly government promoted investments, like building railroads, canals. That changed in the 30s when government insured lenders up to 80% of the cost of private assets, and backstopped banks making loans with only 10% in assets behind them. But the loans banks made required real assets and secure income and priority to those assets.

    But since circa 1980, debt is issued with less and less security, but the interest rates have gone down down down. While consumer credit is easy and very expensive, as 2008-2009 demonstrated, the creditors earning only 1-4% were at highest risk from default on consumer credit with interest at 6%+ for cars, to 35% for consumption goods.

    For every dollar the rent seekers would have lost from no "bank bailouts", the savers who deposited money in short term low risk debt instruments would have lost potentially five dollars in safe short term debt, that would become risky long term debt that would repay 80% in months instead of days, and then up to 98% after three years.

    The capitalists of the rent seekers, the consumer credit firms, sold off shares in IPOs and earned back far more than their original investors, with the shareholders earning returns for years from the high rents extracted from consumer debt, so other than those who bought shares in the decade before the crisis, high returns were earned risk free, and as the crisis came closer and closer, everyone believed they were too big to fail, because failure would harm the savers more. Just like Trump had the advantage over his lenders with his Atlantic City highly leveraged mess.

    Since 1980, the high returns increasingly go to those not taking risks, and the risks increasingly fall on those earning low returns.

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