Believe it or not, total corporate profits in the U.S. are lower today than they were eight years ago.
Reactions when I report this to clients are something akin to the stages of grief: Denial leads to outrage and then, finally, gives way to resignation.
Regardless of where you might be on your progression through these stages, there can be little doubt about the facts. According to the U.S. Bureau of Economic Analysis (BEA), total after-tax corporate profits were 2.3% lower in the third quarter of 2019 (the latest period for which data are available) than they were in the first quarter of 2012. (These numbers are before adjustments for inventory valuation and capital consumption.)
Those stuck in denial about these data point to the growth in the S&P 500’s earnings per share over the past eight years: More than 50%, in fact, according to Standard & Poor’s. How can you square that with the assertion that corporate profits haven’t grown?
While there is no one answer to the question, two factors stand out. The first has to do with the difference between total earnings and earnings per share. If the number of shares has declined, then EPS can grow even while total earnings stay constant. And that is indeed the case in recent years, due to share buybacks.
To be sure, U.S. corporations have also increased the number of their shares outstanding, in large part because of the shares and options they grant to their senior executives. Other things being equal, of course, share issuance will dilute earnings per share. But at least in recent years, share repurchases have outpaced new share issuance.
It’s not easy to determine the relative impact of new share issuance and repurchases. That’s because companies do not, until well after the fact, publicize how many shares they have actually repurchased. Though companies make a big deal of announcing new share repurchase programs, those programs simply give them the ability to repurchase shares but not the obligation.
The definitive guide to the relative impact of repurchases and share issuance is the divisor that index providers use to calculate each day’s index level. In the case of market-cap indices such as the S&P 500, that level is equal to the combined market cap of all stocks divided by the divisor. That divisor rises when share issuance outpaces repurchases, and falls when the opposite is the case.
As you can see from the accompanying chart, after rising during the financial crisis, the S&P 500’s divisor over the past decade has steadily declined. This is one big reason why the S&P 500’s EPS growth has been so robust in an era in which total corporate profits have been flat.
The other major factor at play is the different accounting methods used to calculate profits. James Stack, editor of the InvesTech Research advisory newsletter, explained the difference this way in a recent issue:
“Corporate profits [as reported by the BEA] are primarily calculated using tax accounting while S&P 500 earnings use financial accounting… [Tax accounting] is more reliable for many reasons, including the fact that the BEA adjusts for non-reported and misreported income. Moreover, financial accounting can be more easily manipulated, and the management teams of large public companies take full advantage of this fact.”
It’s interesting to note that both of these factors are related, insofar as both focus on the financial engineering in which companies engage to put their best profit feet forward. That doesn’t mean we have to believe them, however.
There’s a particular reason to worry about this financial engineering now, by the way.
Stack argues that the recent years’ divergence between flat total corporate profits and EPS growth “bears a worrisome similarity to the Tech Bubble of the 1990s.” He notes that the S&P 500’s P/E ratio, which is calculated based on EPS rather than total profits, is already higher than more than 90% of comparable readings of the last century. “But taking into consideration the fact that today’s earnings have almost certainly been manipulated higher (which skews the P/E ratio lower), it becomes clear this is one of the most overvalued markets in history.”