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Profit Margins: New Era Or Reversion To The Mean?

We write about valuations on a relatively frequent basis. However, we rarely get into the profit margin debate. Joel Greenblatt believes that current profit margins are sustainable, while many others believe that profit margins will go down as they revert to the mean. Our colleague Meb Faber has a great article on this topic. Below is a brief excerpt and a link:

“Clearly the first two elements of Exhibit 2 are all about cyclical adjustment: we are assuming that the market goes to a “normal” P/E based on “normal” E. Therefore, it is no surprise that we see the same point from a different perspective when we look at a comparison of the simple trailing P/E using the Graham and Dodd P/E (Exhibit 3). The latter tries to smooth out the business cycle’s impact upon earnings by using a 10-year moving average of earnings. Hence, differences between the two measures are a statement of how far earnings are from their “trend.” The simple trailing P/E is around 15x and the Graham and Dodd P/E is around 24x, again highlighting the divergence of profits from their long-run normal levels.”

S&P 500 GMO 7 year forecast

The Margin Debate