Analyzing Corporate Margins As S&P500 Free Cash Flows Hits Record

Tyler Durden's picture

In the recent multiple expansion run up, one of the largely ignored factors has been the dramatic rise in corporate margins, be they Gross Profit, EBITDA, Net Income or unlevered Free Cash Flow. Of course, all this has been a function of massive cuts in corporate overhead as most companies have laid off the bulk of their workers, resulting in a seemingly stronger bottom line. In the meantime, assorted stimulus programs by the government have prevented revenues from crashing, thus boosting EPS, on both a historical and a projected basis. We demonstrate the dramatic surge in margins by scouring through the S&P 500 companies over the past 3 years, and question just how sustainable this margin pick up is. As more and more analysts predict that future margin expansion is sure to drive the market higher, we can't help but wonder 1) with stimulus benefits expiring and excess liquidity approaching an inflection point (especially in China) who will keep the top line strong, 2) as companies are forced, as a result, to hire more workers in order to drive sales, how will operating margins maintain their stellar performance, and 3) how will a decline in margins be justified from a multiple expansion standpoint. Lastly, we parse through the thoughts of William Hester of Hussman funds, who has some very critical observations on this very relevant topic.

As the chart below demonstrates, virtually every margin metric is now trading at or above its 3 year average.

One notable observation is the unlevered Free Cash Flow margin, which at 12.6% is now at a recent record. We have preciously discussed how companies have extracted major cash concession by squeezing net working capital, which is likely a factor in the disproportionate rise in FCF margins relative to all other metrics. The immediate result of this cash conservation has been of course the dramatic increase in corporate cash balances, which some have speculated is merely in anticipation of much higher corporate tax rates down the line, as well as general austerity as the reality of America's insolvency trickes down to individual corporations.

The take home here is that margins have likely little room left to grow. This is especially true if indeed corporate hiring, as the propaganda goes, is set to resume. Why this is relevant, is because as Hussman Funds' John Hester points out, analysts are already pricing in a return of corporate margins to 2007 record levels. Well, at least as Free Cash Flow margins are concerned, we are already there. Just where will the additional boost in productivity come from?

From John Hester:

Since traditional measures of valuation are
broadly overvalued, analysts who are recommending additional equity
exposure tend to use P/E ratios based on future estimates for operating
earnings. On that measure stocks are still overvalued, but less so. But
the current forward operating earnings may be overly optimistic once
you back out the assumptions they rely on. More modest assumptions
would suggest that the market is overvalued even on forecasted

Analysts forecast that the
S&P 500 companies will $78 by the end of this year, $93 through
next year, and $106 through 2012, based on analyst estimates tracked by
Bloomberg. That's an expected jump of 25 percent this year, 20 percent
next year, and another 14 percent the following year. Clearly, stock
analysts aren't buying the New Normal.

I've noted before, these earnings growth estimates are inconsistent
with what the economics community is expecting from the overall
economy. Economists are forecasting 3 percent real growth both this
year and next, with about 2 percent inflation. Corporate earnings
typically grow more quickly than the economy when coming out of a
recession, especially when profits take the kind of hit that they have
experienced the last couple of years. But the ratio of expected
earnings growth over the next few years versus expected economic growth
still sits far outside of the average ratio of the two (see: Earnings Growth Forecasts May Require a Robust Economic Recovery) But
the aggressive expectations in forecasted earnings growth rates rest
not only in corporate performance detaching from the economic climate,
but also from corporate fundamentals veering far from their long-term
typical performance. The clearest example of this is in the
expectations for profit margins.

earnings growth expectations are steep, sales growth expectations are
more modest. Sales-per-share for S&P 500 companies is expected to
grow about 5.5 percent this year and about 7 percent next year,
according to forecasts. The difference between the growth rates of the
top and bottom lines is implies a forecast for sharply rising operating
profit margins. The graph below is updated from an earlier piece, and
includes forecasts through the end of 2012. It plots the long-term
level of S&P operating margins in blue. In red, I've plotted the
operating margins currently being forecasted by analysts based on their
projections for sales and earnings. Last October, analysts were about
half way to pricing in profit margins that matched the record levels of
2007. Now, they are just about there.

forecasted operating margins are important to investors who rely on
using a P/E multiple based on forward earnings. Even with these
forecasts for near-record profit margins, valuations on forward
operating earnings are not favorable.
The current multiple is about
14.8. As John Hussman has noted
, the long-term average P/E ratio based on forward operating earnings
is about 12. Taking the 14.8 multiple at face value implicitly assumes
that the near-record profit margins assumed by analysts are now the
long-term norm. Even a minor lowering of expected profit margins would
cause the scale of the overvaluation to widen materially
. Considering
the aggressive expectations for profit margins, the market's valuation
based on expected results may be as stretched as it is on trailing

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Deep's picture

Who cares, this market is rigged, does it matter


they are  gonna gun it higher


but very good analysis

Cursive's picture


Summed it up nicely.  Forget analysis.  Forget "investing".

Apocalypse Now's picture

Based on Greenspan's belief that the economy follows the market, they believe pumping the market will stimulate the economy.  It does keep people's attention on something that has random walks and not focused on the important philosophical issues of the day.

A must for all ZeroHedgers, it explains our system well:

Sign up for SwarmUSA as well.

hedgeless_horseman's picture

More trees growing to the sky.  Happens all the projections.

ZeroPower's picture

ROE, when decomposed, is a function of profit margin, asset t/o, and leverage. Using clever accounting methods are the simplest (and legal!) way of making sure your company maintains its AAA (or whatever as arbitrary) rating.

fuggetaboutit's picture

I dont even understand this - the profit margins at the last peak were a function of an amount of excessive leverage and consumption that basically blew the system to pieces, globally - with leverage coming out of the system and consumption nowhere near where it was, how is it even mathematically possible to get margins basically right back to where they were?

carbonmutant's picture

They've been using the recession to reduce their bottom line costs. And the cost of borrowing has been cheaper.

ZeroPower's picture

Since the major factor in keeping your operating margins up is keeping your expenses at a low, zero interest rates have greatly benefitted these multiples that we see going through the roof.

If youre a small business owner or even worse, retail, forget about getting nice terms on a loan. However, be the CFO of a firm on the S&P and i have no doubt your options in terms of financing are much more attractive.

The other input for operating margins is revenues - and we can safely assume those are NOT back to 2007 levels.

Fritz's picture

Since when, exactly, have fundamentals mattered in this market?

It will be interesting to see what happens on the other side of this quarter-end window dressing ramp.


William Wallace's picture

An average P/E of 14.8 might actually be low in a zero interest rate environment.  It is only if and when interest rates to some normal level rise that P/E 14.8 is too high.

The bank and finance sector "profits" that are included in this graph are bogus.  But investors may know that and not care.

We may be living in an age of zero interest forever and bogus accounting forever.  In such a world, what is an appropriate average P/E?

Denninger says that cash flow will always win out.  He thinks that lack of cash will bring down the banks someday.

Rasputin, at Wallstreetbear, believes more that infinite fiat can infinitely keep the cash flow going. 

I am beginning to side with Rasputin on this.  By buying bank stocks, an investor can get his share of infinite fiat, infinitely flung.

Chopshop's picture

it's different this time thinking is precisely what mr. mkt must imbue across the land before he can bend investors over again.  most investors were cut in half (or worse) on the way down and most investors have sat out this reflex rally.

there is no systemic inflation in america (sans high fructose corn syrup and intellectual laziness) outside of targeted financial intermediary credits being electronically swapped (ie. not printing), which really aren't much at all, and when combined with M3 and / or velocity of M1 are simply beyond laughable in the face of overarching deflation.

there is no volume to speak of within US equities (cited daily by Tyler), which speaks more to dis-interest and apathy ... there is anemic loan growth (outside of rollovers) and virtually no one outside of finance has an interest in taking capital to put to use.

the infinite fiat argument isn't even an argument, it is a fairy tale that lacks practical application; a cyclic occurrence sprouting up across history that presages critical change. these are dramatic times but they aren't wholly unique.  those looking to examples of weimar and zimbab ought crack open kindleberger and a cold one for a wee bit of historical framing.

for simplicity: where have the P/E ratios of US equity 'bear mkts' bottomed in the past hundred years ?  4 - 8.

much more relevant is looking not only at P/B and P/S ratios but also at dividend ratios.  that has proven itself time and time again for the nature of crisis we face.  plus, inputs for P/E, P/B and even P/S are distorted by basic machinations and what the hell accounting methodology are we even employing (past decade's GAAP is total crap) ... and finally, because of the bank-centric nature of this period with reverse-splits, cap infusions and other overt chicanery, the 'value' of information within price / dividend ratio is further underscored.

Apocalypse Now's picture

Great points Chopshop.

In addition, there is substitution bias - the dow added 640 points from taking out GM & Citibank and adding Travelers & Cisco.  If you look at the entire history of the Dow, it would be at zero except for GE that "survived".

Now fiduciaries administering pension funds have actuarial investment assumptions requiring 7-8% investment returns to overcome their pension payment liabilities but have fallen short for the last 10 years.  With depressed bond yields from low rates and zero return on money market savings, pension funds are looking at more risk assuming there will be more return.

Lastly, Bill Gross's point on Uni-Credit is important.  The government/tax payers have been saddled with the worst of the assets including under water mortgages.  Why invest in a government Acorn bond (or pick the name of any other ridiculous gov program based on the ability to tax future incomes) when you can invest in a multi-national corporation that has diversified cash flows across the world and operates at surpluses (not deficits)? 

Corporate quality bonds and preferreds look like better quality than governments to me.  And although they don't have their own military, history shows the military will protect their interests.


The low volume is also worth talking about.  Volumes are 50% of what they were in 2007, and of that 80% of volumes are traded in Citi, Bank of America, AIG and Wells Fargo.  Perhaps that is to boost the perception of volumes with computers passing the stocks back and forth.

The people running the system have significant control over the market under these circumstances.  With each iteration of the deflation/inflation cycle I am sure wealth is being concentrated in fewer hands, and it would be interesting to know real ownership percentages by family.  A number of trusts, corporations, and shell companies are used so true ownership is not easy to determine.

Advocatus's picture

Committee of 200 is the answer.

There are few families in the world that control almost 90% of the world's wealth. And the fact is that USA is in their hand. Read the history of the Feb...

William Wallace's picture

I have sadly concluded that all the hours I have spent learning fundamental stock analysis have been wasted, and that the decisions I have made based on that analysis have been wrong.  I should instead have studied the Fed the way the old Sovietologists used to study the Politburo.

What will the Fed and the PPT do?  I agree that they will not bring about Weimar meets Zimbabwe.  That would be suicide for them. They will move to protect themselves and TPTB, who are important people who could hurt them.

If you agree that a stock market crash would hurt the Fed, hurt TPTB, and hurt the Fed's reputation with TPTB, then you will conclude that the Fed will do whatever it can to avoid another stock market crash.

This means that they will fling infinite fiat up to the limit of getting themselves in trouble with inflation.

This analysis predicts more fiat for the banks, more puffery of bank profits, and a higher stock market.  The S&P div yield of all div paying stocks is 1.77%.  With 2-year Treasury at 1.1%, more multiple expansion still is possible there.

scofflaw's picture

Of course, all this has been a function of massive cuts in corporate overhead as most companies have laid off the bulk of their workers...,

Really...most companies have laid off the bulk of their workers?  Talk about hyperbole.

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