Are Corporate Profits As Good As Some Claim?
On January 28, 2020, an Associated Press dispatch proclaimed: “Corporate Earnings Good Despite Headlines”, stating that “corporate profits remain very healthy overall, and the majority of corporations are beating expectations.”
Michael Mauboussin, chief investment strategist of a large fund management group, in the report cited in “Legg Mason Argues For More Efficient Stock Buybacks“, also wrote in January 2006 that “corporate America is flush, and returns and cash flows remain strong.”
Are these assertions true and does this mean that the outlook is rosy for the average investor in U.S. equities?
As the Federal Reserve national flow of funds table F102 reveals, the answer is,
“Yes, U.S. corporations are flush with cash and profits are growing”, and
“No, this does not mean the outlook is rosy for the average investor in equities.”
The reason for this apparent contradiction is that the most practical and useful measure of value for corporate profits depends on who you are.
Corporate Profits for Executives
From the point of view of corporate executives that have effective control over how the cash of the company can be spent, the most important indicator of corporate profits is simply cash flow.
Cash flow is the sum of profit-after-tax and depreciation (or, in the flow of funds an amount called “capital consumption allowances”, calculated by economists.)
It is the amount of cash generated each year that can be used to fund dividends, buybacks, takeover of other companies, maintenance of current facilities, building new facilities, new projects, or whatever else executives think worthwhile.
In theory, depreciation (or the capital consumption allowance) is the expense of maintaining plant and equipment at current levels.
In practice, depreciation is an accounting fiction with tax benefits, that may or may not be related to the cost of maintaining a certain level of fixed investment.
The Federal Reserve national flow of funds accounts for corporations do not show accounting depreciation, but rather “Capital Consumption Allowances”, taken from table 1.16 of the Survey of Current Business, defined as follows:
The charge for the using up of private and government fixed capital located in the United States. It is the decline in the value of the stock of fixed assets due to wear and tear, obsolescence, accidental damage, and aging. For general government and for nonprofit institutions that primarily serve individuals, Consumption of Fixed Capital serves as a measure of the value of the current services of the fixed assets owned and used by these entities.
- This number is calculated by economists, rather than by accountants, and is probably more realistic than accounting depreciation, but is still a matter of opinion.
With outsourcing of production, asset-lite management, productivity gains, and technological advances, no conclusion is likely as to the adequacy or even the practical significance of current levels of depreciation or the economists’ capital consumption allowances.
The difference between cash flow and net-profits-after tax is startling, as the graph below indicates.
Over the five years 2001-2005, this difference totaled $3.6 trillion! This was well over twice the amount of federal government deficit spending during the recent recession and the wars in Afghanistan and Iraq.
 Different Views of Corporate Profits
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Furthermore, cash flow has been growing nicely at an average annual rate of over ten percent. So, from the point of view of corporate executives, it is correct to say that corporate profits are indeed growing and that business is truly flush with cash.
Corporate Profits for Long-Term, Ordinary Investors
Well over seventy million Americans own equities.
Usually this ownership is indirect through mutual funds or retirement plans. The typical U.S. shareholders will hold a diversified portfolio of equities, managed by someone else, for twenty or thirty years.
Although fund managers buy and sell stocks in the portfolios they manage, as a group this trading tends to cancel out, so that the net effect to the average long-term shareholder is the same as if he or she held an unmanaged index fund over the long years until retirement.
At the end of a decades-long holding period, long-term equity investors get almost no benefit from transitory variations in stock prices caused by corporate buyback programs over the decades. Corporate money spent on buybacks went to someone else, not to them.
Because, on balance, the typical investor holds stocks for the long term, the only ‘profits’ received come as cash dividends, which may be reinvested.
From the point of view of long-term investors, stock buybacks are simply remuneration paid to corporate executives and other insiders. Such payments should be considered an expense and deducted from net profits after taxes (whether or not this practice conforms to accounting practice.)
As seen in the graph, the growth of profits for long-term investors (the green line) and the growth of dividends (the dark blue line) are far less impressive than the growth of corporate cash flow.
In fact, profits for long-term shareholders (i.e., with buybacks expensed) have been insufficient to cover dividends, and dividends have been declining since 2004.
Corporate Profits for Stock Speculators and Tax Officials
Accounting profits (income less expenses, taxes, and depreciation) are shown on the graph by the red line and seem to have grown quite impressively over the period 2001-2005.
Accounting profits are used to calculate things like earnings-per-share, price-earnings ratios, and corporate income taxes. Such things are useful and valuable to market speculators and tax collectors.
However, long-term investors cannot pay costs of nursing homes or vacations in their ‘golden years’ with earnings-per-share, or with the transitory unrealized capital gains of winters long gone.
Buybacks Reward Executives and Dupe Ordinary Investors
The great majority of long-term investors, holding equities in retirement plans and confiding in the ‘expertise’ of professional managers to protect their interests, lack the sophistication to understand the degree to which they are misled by corporate management, market intermediaries, the accounting profession, and the Securities and Exchange Commission.
For further background on how ordinary investors are duped, see the essays on “Stock Buybacks and Options”.
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