Thursday, September 17, 2009

Profits & Profit Margins

The Lehmann Letter ©

The stock market has done well over the past half year despite a limited recovery in corporate profits.

Chart 2.1 Profits

(Click on image to enlarge)

Recessions shaded

Perhaps investors’ enthusiasm has something to do with a much stronger performance by profit margins.

Chart 2.3 Profit Margins

(Click on image to enlarge)

Recessions shaded

You can see that profit margins continued to grow throughout the recession even as total profits fell. Recall that total profits = Profit margins X sales volume. If sales volume plunges by more than margins improve, total profits will fall. That’s what happened in 2008 – 2009.

It’s easy to understand why sales volume fell. But why did margins improve? The chart measures profit margins by dividing the change in prices business receives (numerator) by the labor cost per unit of output that business sells (denominator). Remember: Price = Revenue per unit of output sold. Examining the chart once more, it’s clear that revenue per unit of output sold (numerator) grew more rapidly than cost per unit of output sold (denominator). That is, margins (price/cost) rose.

But let’s not beg the question. Why did costs rise less than prices? Credit the New Economy. Business continues to improve its productivity (efficiency) by mobilizing technology to raise output per worker. More output per hour of work = Less time required to produce a unit of output. If it takes less time to produce a unit of output, that unit of output will cost less provided wages have risen slowly.

That’s key. If wages rise less rapidly than output per worker (productivity), unit labor costs (the cost of producing an additional unit of output) will fall. And, since wages have risen slowly lately, unit labor costs have indeed risen less rapidly than prices. The bottom Line = Profit margins (prices/costs) have grown.

Improved profit margins will be very good for earnings when sales volume recovers. It appears that investors have bid up stock prices in anticipation of this event.

(The charts were taken from [Click on Seminars and then Charts.] Go there for additional charts on the economy and a list of economic indicators.)

© 2009 Michael B. Lehmann

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