Forward Earnings Imply a Return To Near-Record Profit Margins
William Hester, CFA
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The earnings reporting season officially kicks off this week when Alcoa releases results on Wednesday. Investors may appreciate the change in focus from economic data to corporate fundamentals. The economic data surprise line that we track – which measures how economic data is coming in relative to expectations – turned down noticeably during the last two weeks. Not that the corporate profitability picture will look much better. Earnings are expected to decline again this quarter to about $38 a share on a 12-month operating profit basis (earnings excluding writedowns and restructurings). That figure will be down 40 percent or so from a year ago.
But investors will be looking forward, not backward. An assumption that the recession has ended was likely discounted much earlier in the recent stock market rally. At these levels it seems that a full-blown V-shaped recovery is being priced in. There's no better example of a V-shaped forecast than for what is expected for the recovery in earnings over the next couple of years. The graph below shows the operating profit series, which includes actual results from the second quarter of 2007 – when earnings peaked – through this year's second quarter, and then continues with estimates through the end of 2011.
For operating earnings to get back to their peak levels, analysts have penciled in earnings growth of more than 40 percent over the next year, and then another 22 percent between 2010 and 2011. These expectations sit far above what is expected from overall economic growth, where growth forecasts are more modest. There's a couple of ways companies could deliver strong operating earnings growth amid tepid economic growth. One is through a decoupling of the relation between sales growth and economic growth. If companies could grow their top lines in spite of anemic economic growth, then earnings could grow at higher rates than is typical when compared to the overall growth in the economy.
But when you look at what analysts are expecting for revenue growth, this is not the case. The graph below shows the typical relationship between sales growth and changes in nominal GDP. Not surprisingly, robust economic growth usually coincides with stronger top-line growth. The current sales per share for the S&P 500 is $922. Analysts expect sales to jump 5 percent next year and then another 8 percent into 2011, according to Bloomberg data. Meanwhile, economists expect the economy to grow by a little more than 4 percent year over year. The graph shows that while the relationship between expected sales growth and expected GDP growth doesn't sit directly on the best-fit line, it is within a cluster of historical data that suggests that the relationship suggested is not inappropriate.
The next graph shows the typical relationship between the year-over-year change in operating earnings and the year-over-year change in nominal GDP. This graph is updated from Earnings Growth Forecasts May Require a Robust Economic Recovery . A comparison to the earlier graph shows that economists have been raising their forecasts for economic growth over the next year. Still, the forecast for earnings growth sits far outside of what would be expected based on the historical relationship between earnings growth and economic growth.
Of course, this isn't a difficult riddle to solve. If sales are expected to grow modestly, and in line with economic growth, but earnings are expected to rise far and above what can be explained by economic growth or sales growth, then analysts must be assuming aggressive expansion in profit margins.
The graph below shows the profit margin for the S&P 500. The blue line captures data from 1955 up through the second quarter of this year. The maroon line plots the operating margin expected by Wall Street analysts over the next couple of years. I backed this data out of analysts' forecasts for sales and earnings over this period.
Analysts are forecasting that profit margins will reach almost 8 percent next year and then 9 percent by 2011, far above their recent trough and far above the long-term average (the tan-colored line) of about 6 percent. The graph shows that revisiting the earnings peak of $90 a share in 2011 will require a return to profit margins that are far above the long-term average.
Because the largest companies ran into the biggest problems the last couple of years, index-level earnings and profit margins have been volatile. The profit margins leading up to the peak in earnings in 2007, for example, were distorted by the large share of index earnings contributed by financial companies at the time. Financial companies had the largest share of earnings in the index and had the highest profit margin of the 10 S&P sectors (see Profit Margins, Earnings Growth, and Stock Returns ). And those profit margins grew impressively through the decade leading up to the middle of 2007 – net margins for the financial sector climbed from 8 percent to 14 percent during the period. With this lopsided contribution to index-level earnings at the peak, and considering the spectacular collapse of the group's results in 2008, there may be different information available by looking at the typical stock.
The graph below attempts to do this. It shows the median profit margin of the companies in the S&P 500 going back a decade, a period where margins have mostly been above the long-term average. The maroon line shows the median profit margin backed out by using estimated sales and earnings for the companies within the S&P 500 over the next couple of years. The graph shows that expectations are even more aggressive when considering the typical stock compared with index-level results. By the end of 2011 the median profit margin is expected to be essentially at record levels again.
What's noteworthy in this analysis is not simply that margins are expected to recover. Margins typically do expand following recessions as sales pick up and businesses are slow to hire and invest because of continued uncertainty. What is worth highlighting is that analysts expect that the typical company will soon achieve the same level of profit margin that they were able to deliver in the years leading up to 2007 – a period where leverage was preferred over balance sheet strength, a preference by company managements to focus on equity shareholders, during a political climate where labor lacked bargaining power, where consumer spending was fueled by mortgage equity withdrawals, and leverage ratios increased broadly because business and consumer credit was easy to come by. To assume a return to peak profit margins is a bet that the economic and political landscape that emerges over the next year or two will match the pre-panic landscape perfectly.
While S&P earnings may not be able to rise to the lofty expectations of analysts over the next couple of years, this isn't a strongly bearish argument in itself. The link between near-term earnings and stock direction is tenuous. Outside of very large changes in earnings, there is essentially no correlation between year-over-year changes in earnings and changes in stock prices. But if you're investor that is sensitive to valuation and your preference is to use forward earnings, then an understanding of the building blocks that create those earnings estimates is important.
Here are some what-if scenarios using year-ahead earnings estimates (keeping in mind that profit margin estimates grow even more aggressive two years out). Currently, analysts are expecting $75 a share in earnings next year, from $975 a share in sales, reflecting an expected profit margin of 7.7 percent. On that measure, the price to forward operating earnings ratio is 13.7. John Hussman has estimated that the long-term price to forward operating earnings ratio is about 12 in data that includes the late 1990's bubble, and 10.6 in data prior to that (see Long-Term Evidence on the Fed Model and Forward Operating P/E Ratios ). So assuming that analyst expectations for strong margin recovery are correct, the P/E is already at least 1.7 points above the long-term average. Assuming a 7 percent profit margin on next year sales, the P/E ratio would currently sit about 3 points above the long-term average. And at the long-term average profit margin of 6 percent, the P/E ratio on forward operating earnings would sit 5.5 points (nearly 50%) above the long-term average.
This closely mirrors valuation analysis that uses normalized earnings - the market is no longer undervalued, and is now trading generally above long-term valuation norms. That's the case for normalized trailing earnings and also for forward operating earnings. Given these expectations, the ability for companies to beat earnings estimates may eventually become more challenging. Since aggressive profit margin expectations are already assumed, big earnings surprises would require companies to deliver those already expected high profit margins, and probably stronger than expected top-line growth too.
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