Saturday, February 12, 2005
The Economist states the obvious
Well, at least it should be obvious: over the long-run, corporate profits can't grow faster than nominal GDP. I wish, however, that the article also mentioned the following:
- There is a big difference between the GAAP earnings that public companies report, and the corporate earnings that are measured in the GDP national accounts (in particular, the latter excludes amoritization and depreciation). Over the long-term, the two should grow at more or less the same pace, but over short intervals, there can be big divergences. The biggest one was during the late nineties, when reported earnings grew very quickly, but earnings in the national accounts did not.
- While aggregate earnings do tend to grow at the same pace as GDP over the long haul, the earnings of the average company grow at a slower pace. The reason is that the total number of companies is always increasing. Moreover, per share earnings tend to grow even more slowly because of share dilution (which historically has averaged about 2 percent of outstanding shares per annum).
- Inflation tends to distort the true measure of earnings. When inflation is high, nominal interest rates are also high, so companies incur much higher interest expenses. This reduces reported earnings. However, true 'economic' earnings do not necessarily decline with inflation, because inflation also erodes the real value of debt outstanding. While this may seem like an esoteric point, it has important consequences. Back in the late seventies, many economists noted that stocks were extremely undervalued because inflation was artifically depressing reported earnings, and that the true market P/E ratio was a lot lower than most people believed. This implied that stocks were extremely underpriced. Those who listened to these words of wisdom and bought stocks in the early 1980's as inflation was starting to come down would have found themselves on the ground floor of one of the greatest Bull markets in American history.