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 fundamentals.
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.
As 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.
While 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.
These 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 fundamentals.