When a company charges a customer for something, how much of that money they get to keep is the profit margin. If you buy something for $1, and the company’s net income goes up by six cents, the profit margin is 6%. If their net income goes up fifteen cents, the profit margin is 15%.
Corporate profit margins have gone up and down throughout history. I have no idea where profit margins are headed, but we are currently at 15%, which is historically high. For instance, we were at 4% in 1991 and 8% in 1997.
Profit margins are something to think about. It is not politically palatable for profit margins to get too high. If profit margins were 50%, taxes would most likely be raised. Further, if we really have capitalism, fat profits should be competed away. If a company has a profit margin of 50%, other entrepreneurs out there are more than happy to compete head to head and take only 40% margin.
To me, PE ratios and profit margins convey headwinds or tailwinds to your investments. For instance, if you invest when PE ratios are low and profit margins are low, if they both expand, you get bonus expansion on your return. However, if you invest when PE ratios are high and they both contract, you get headwinds to your return.
For instance, if the S&P 500 is purchased when profit margins are 4% at a PE of 15, if profit margins expand to 8%, you’ve doubled your money if you can sell at a PE of 15. If you can sell at a PE of 30 because people are excited that the earnings have doubled, you’ve quadrupled your money, even though total revenue hasn’t changed at all. Earnings went up and the valuation of those earnings (PE) also went up.
The opposite can also happen. If you buy the S&P 500 when profit margins are 15% and the PE is at 23, as it is today, you are relying on profit margins to stay the same or expand. The same with the high PE. It doesn’t mean you’ll be wrong. Perhaps the government removes all corporate taxes and only taxes individuals. Perhaps entrepreneurs don’t want to compete anymore. Perhaps companies stop investing in new technologies and growth.
As always, I have no idea what is going to happen going forward. What I do know is that we more likely have a headwind than a tailwind from where we stand today. A margin of safety could help with any contractions in profit margins due to tax increases, recessions, or just plain ole capitalism.