In a prior piece, I argued that that the frequently-cited macroeconomic expression “CPATAX/GDP”, shown below in maroon (FRED), is a flawed way of measuring the aggregate profit margin of U.S. corporations.
When a U.S. corporation earns profit from foreign operations, “CPATAX/GDP” counts the profit in the numerator, but doesn’t count the costs of the profit–the wages and salaries of the employees of the foreign operations–in the denominator. All else equal, the omission causes the profit margin to appear larger than it actually is.
If the share of U.S. corporate profit earned abroad were constant across history, then the profit margin overstatement inherent in “CPATAX/GDP” would occur equally in all years of the data set, and therefore a comparison of the present values of the metric to the averages of past values would still potentially be valid. However, the share of profit earned abroad has not been constant across history. In the last 60 years, it has increased dramatically–from less than 10% in 1948 to more than 40% in 2014. Any comparison between the present values of “CPATAX/GDP” and the averages of past values is therefore invalid.
In place of the flawed “CPATAX/GDP”, I offered a more accurate profit margin metric–domestic profit divided by domestic final sales (GVA: gross value added), shown below in blue (FRED):
This metric divides the domestic profit of corporations by the revenue from which that profit was generated. All costs associated with a given unit of profit are included in the denominator, therefore the previous overstatement is eliminated.
Unfortunately, not even this metric allows for a valid comparison with the past. The reason the metric doesn’t allow for a valid comparison is that it fails to distinguish between financial and non-financial profit. Historically, financial profit has been earned at a much higher profit margin than non-financial profit. If the share of financial profit in total profit were constant across time, the distinction wouldn’t matter. But, as before, that share has not been constant across time–it has increased substantially. A comparison between the present values of the metric and the averages of past values is therefore invalid.
NIPA Table 1.14 conveniently divides total corporate revenue (GVA) into non-financial sector revenue (Line 17) and financial sector revenue (Line 16). The following chart shows financial sector revenue as a share of total corporate revenue from 1947 to 2013 (FRED):
As you can see, the share has tripled, from 4% in 1947 to 12% in 2014. Now, if financial profit were earned at roughly the same profit margin as non-financial profit, the increase would not matter. But, as it turns out, financial profit is earned at a much higher profit margin–more than twice as high. This isn’t a recent phenomenon–it’s been the case since at least the 1920s, as far back as the NIPA data goes.
The following chart shows the profit margin of the financial sector (red) alongside the profit margin of the non-financial sector (green) from 1947 to 2013 (FRED):
As you can see, the average profit margin for the financial sector is more than twice as large as the average profit margin for the non-financial sector, with the pattern consistent all the way back to the 1940s. Given that the share of profit that goes to the higher-margin financial sector has increased, we should expect the total corporate profit margin to have similarly increased. Any comparison of the total corporate profit margin with the averages of past periods needs to account for the increase.
The optimal way to account for the increase is to drop financial profit altogether and focus only on non-financial profit–profit generated from productive operations in the real economy. The following chart shows the non-financial sector profit margin from 1947 to 2013 (FRED):
When it comes to making comparisons with the past, this chart is the most accurate chart of profit margins available. To be clear, non-financial profit margins are elevated, but they are less elevated than aggregate profit margins, and nowhere near as elevated as the bogus “CPATAX/GDP” was suggesting.
The following table lists each type of profit margin alongside its historical mean, current elevation, and the annual drag that profit growth would suffer if the profit margin were to revert to the mean over the next 10 years:
Interestingly, the aggregate domestic profit margin is currently more elevated relative to the past than both the financial and non-financial profit margins that make it up. The reason this is possible is that the share of profit going to the financial sector has increased.
Returning to the chart, rather than being 25% above the highs of prior cycles, as we were with the bogus “CPATAX/GDP”, we’re actually still below those highs–both the high registered in 1966, and the high registered in 1949. In terms of past precedence, it’s therefore entirely conceivable that profit margins could continue to trek higher in the current cycle. That is, in fact, what seems to be happening. With approximately 94% of S&P 500 companies reporting earnings for the first quarter, the trailing twelve month net profit margin for the index is on pace to register yet another new high: 9.67% on operating earnings (as tallied by Howard Silverblatt of S&P), and 8.95% on GAAP earnings (company-reported).
On Twitter, economist Andy Harless made a clever point that replacing “CPATAX/GDP” with these more accurate metrics may actually help the valuation bear case, because the more accurate metrics don’t exhibit a “breakout” to new highs in the same way that “CPATAX/GDP” did. If valuation bulls embrace the more accurate metrics instead of “CPATAX/GDP”, they will no longer be able to cite such a “breakout” as evidence of a structural shift in corporate profitability.
But, as the chart below illustrates, if we remove the distorting presence of higher-margin financial profits, which have increased over time, the evidence of a structural shift remains intact. In the Great Recession–the worst downturn for the corporate sector since the Great Depression–profit margins didn’t even come close to touching the lows of prior eras. In fact, they barely touched the historical average. In charts that include the financial sector, profit margins appear to briefly fall to record lows, but this appearance is an artifact of the huge credit losses that the financial sector incurred in the period. The profit margins of non-financial corporations remained historically elevated, contrary to what mean-reversion analysis would have predicted.