April 24, 2002
In an earlier column, I hinted that profits would rebound sharply in the next twelve to eighteen months. While profits almost always jump 2 are more times as fast as sales early in an economic expansion, gains of even more than that rate are likely in this rebound.
The first step to developing a profit estimate is to determine sales. The best way to deal with this is to develop an estimate of units sold and then determine gross profit margins from resources acquired. (Of course, a company could also improve purchasing efficiency, but that usually is relegated to secondary consideration).
Let's assume quantities demanded of your product grows in line with gains in household purchasing power. Inflation at 3 percent, wages expanding 3.5 percent, some growth in overtime pay and a rebound in paychecks by 1 percent as employment expands will lead to slightly more than 2 percent growth in units.
If you are diligent and increase market share, maybe you can double the growth in units sold.
The next issue is pricing power. If you are providing hospital services, the ability to raise prices may be considerable. (With inflation expanding 1.5 percent in the past twelve months, hospital fees have expanded more than 8 percent). If your competition is from abroad in some commodity, your pricing power is very limited.
Most companies lose pricing power during recessions because other companies are willing to sell only slightly above the cost of producing another unit in order to pay something on their fixed costs. As the economy expands, pricing power slowly rebounds. I certainly believe pricing power will increase this year, but not by much.
Therefore, we arrive at sales growth of about 5 percent in my hypothetical company.
I already talked about hourly labor costs. However, economists must also consider how many units each laborer can produce in an hour. Of course, this is different for each company and depends upon the skills and experience of the workforce, the amount and effectiveness available capital and the skills of the managers.
For the entire economy, productivity has been surprisingly strong during a recession. When the economy performs below its capabilities, people are not being used as effectively as desired. Even with layoffs, companies cannot easily "right size" as sales are falling.
When sales begin rebounding, those efficiencies return. For a short period of time, productivity gains are better than normal. With trend productivity gains running above 2.5 percent, actual increases of 4 percent in productivity would not be unusual in the next year.
Thus, the cost of labor per unit of production should fall slightly during the next twelve to eighteen months.
Partially offsetting favorable labor costs will be deteriorating finance cost containment as short term interest rates begin to rise. However, many companies have used borrowing arrangements that preserves relatively low finance costs for a year or more.
Other costs are associated with regulations, tax policies, and special commodity factors, such as the fluctuation in energy prices. While some favorable trends exist in tax policy, they probably are offset by unfavorable trends in the cost of energy.
When all these factors are combined, profits may grow about half a cent for every dollar of sales.
Many people believe that profits are inordinately large relative to company sales. However, the average company earns only 4 to 5 cents from every dollar sold when it is operating effectively. This half cent improvement in profits because of favorable labor costs per unit produced means about a 15 percent gain in profits.
When that is added to the 5 percent growth in sales, the projected profit growth can be as high as 20 percent.
In fact, my projections for profit growth in the next six quarters is slightly over 20 percent for the entire economy.
Of course, such gains will not persist. Those higher finance charges will begin to bite. Wage pressures will stop falling once pricing pressures resume. Also, those above normal productivity gains are only temporary.
Indeed, two years from now, the average corporation will be struggling to preserve the share of sales that go to profits. In the long run, the share of revenues that go to profits is largely unchanged. In other words, profit growth and sales growth are about the same over time.
What creates the exceptionally strong profit gains that I see just ahead is the favorable productivity gains that occur while wage pressures are still subsiding. Fortunately, such profit growth will justify current stock values for a host of companies. Indeed, if pricing power returns, some of these companies may command superior growth in valuations during the next few years.
Deciding which companies should be on that list is left to the reader.