Profit Growth May Stall

When stock prices rise for too long and lead valuation multiples into uncharted territory, investors typically argue that “this time is different,” coming up with brand new valuation techniques that relate stock prices to very creative corporate variables. This way they attempt to justify maintaining a bullish stance.

Back in the late 1980s, Japanese stocks rose high above their historical P/E multiples as the whole world was attracted by the prospects of Japanese companies. During the 1990s, investors didn’t even bother with any traditional valuation metric when buying dotcom stocks, which were trading at 200x their prospective earnings. In many cases, companies don’t even have a record of profits; instead of looking at earnings investors looked at price per click or per user, and many still do when valuating companies like Linkedin, Facebook, and the freshly debuted Twitter.

In all of the above cases stock prices eventually returned to earth and investors saw their investments decimated. Traditional metrics prove key in the long-term. The story for the housing market is the same along with many other instances. The rule remains: if you follow the crowd without looking at the fundamentals, your investment experience will inevitably end in tears.

Currently we have strong corporate profits, which skyrocketed to a 50-year high in terms of percentage of the GDP. Analysts are estimating a huge increase of 10.9% earnings per share for next year. Everything seems OK, but we must be very careful. A deeper look into these numbers tells a different story than it appears at first sight.

To begin, analysts have been very active revising their initial earnings projections; companies don’t end up beating the initial projections, they beat the revised ones. EPS growth was almost flat this quarter when compared with the last quarter, even though you see many companies beating estimates. As a result, the 10.9% estimated growth for next year may end up being halved, or more, along the way.

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Another important factor to take into account is the fact that companies have buyback shares. While this is great for stockholders, it also inflates EPS as earnings, because the earnings are then split across a reduced number of shares. This means that if EPS didn’t grow this quarter and there are fewer shares, profit in fact must have decreased. But will companies continue to have buyback shares forever?

Profit margins have also been rising, mostly because unit labor costs are flat since productivity rose in 2008. With the unemployment rate above 7%, labor has a reduced bargaining power. This change led to the erosion of its importance, and also resulted in an increase in profit margins. Again, this may be reverted in the near future.

We can’t forget about the current–and very accommodating–monetary policy that could also be reverted in the near future, potentially dragging corporate profits down. Very low interest rates reduce borrowing costs helping to improve profit margins. As seen above, companies took the opportunity to buyback stock and to inflate EPS, but as soon as interest rates increase again, financial costs will drag profits down.

One last item to take into account is business investment. Companies have not been investing in their business, or replacing old software and hardware. Rather, they have been taking the opportunity to let depreciation decrease, ultimately helping to enlarge their profit margins.

All the above factors point to the need to be careful about the future. The growth in profits we are experiencing seem to have a cyclical nature. Companies aren’t improving capacity, investing in new markets, or creating future growth capabilities, they are just getting as much as they can from the aftermath of the financial crisis and the favorable conditions created by the Federal Reserve. When these transitory factors exhale, the market may crash again. The long term valuation metrics will have to return back to historical averages, just like it did in the past.

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