Corporate Profits: Critical for Business Analysis; and Not Just for Wall Street

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The role of profits and return on investment need increasing attention from business and financial economists in order to analyze income through stock prices; identify potentials for mis-pricing stocks; and to understand prospects for investment, hiring, and pricing. The analysis of corporate profits must take account of financial and operating leverage and global influences. Operating leverage, in particular, has played a particularly damaging role in the 2001 recession, as firms became more capital-intensive. Finally, given the importance of profits in macroanalysis, it is critical that the quality and relevance of government statistics be continually upgraded.

As business analysts, many of us produce macroeconomic forecasts that--for all their shortcomings--are key ingredients in business planning and in the analysis of the direction of financial markets and monetary and fiscal policy. Analysts and the business press rightly focus on GDP and its components as the cornerstones of both macroanalysis and measurement. Getting that analysis mostly right is critical for our companies and our careers.

But in my view, analysts spend too little time analyzing the behavior of corporate profits and returns on investment. It's hardly their fault. The average undergraduate textbook on macroeconomics mentions profits at most twice--you guessed it--once in outlining the National Income Accounts, and once briefly in discussing investment. Small wonder that some analysts think a focus on profits is only important for those of us who work on Wall Street, given our obsession with the stock market. In contrast, I think analyzing profits is also critical for those of us who work on Main Street.

There are three key reasons to focus on corporate profits and profit margins. First, and most obvious, the link between Wall Street and Main Street through profitability, stock prices, and their influence on the economy has never been more apparent. Second, analyzing profit margins helps identify what I call critical tension points that may or may not be reflected in market prices. Let's face it: Our efficient capital markets may not mis-price assets for long, but there's no denying the bubble we've just experienced. Analyzing these stress indicators often shows what might have to change, in the economy, markets, or in our companies. Last, and most important, current and expected profitability both reflect--and are key drivers of--investment, hiring, and pricing decisions. Thus, far from just being a byproduct of your forecasts, profits and margins should be an integral determinant of the outcome.

Many of you will protest. After all, profit maximization is a central tenet of modern macro, as well as micro theory, yielding important insights about how companies behave. Since Modigliani and Miller, for example, analysts have recognized that a firm's valuation and its investment policy are inseparable. But conclusions from that neoclassical paradigm often miss the mark for the real world in which we operate. I believe looking directly at profitability and rates of return can help crosscheck those conclusions. Likewise, returns on investment are key determinants of the strategic recommendations that you make to your senior management. But too often our microanalysis lacks a macro profits context to frame the discussion.

To others of you, schooled in the business cycle analysis of Mitchell, Burns and Moore, a focus on profits is second nature. Corporate profits at one time were thought to be a leading economic indicator. According to Mitchell, that is with good reason: his theory of the business cycle put profits at center stage. A period of economic expansion would boost profits and thus business investment. But as operating rates rose, costs would accelerate faster than output. The resulting squeeze on profit margins would curb investment, triggering recession. Cost cutting in the slump would restore margins and lay the groundwork for recovery. …