Amid concerns that the S&P 500 (INDEXSP:.INX) is growing too quickly, and that price to earnings ratios are too high to be sustained, there may be room for more growth by companies improving their operating margins. According to Tobias Levkovich at Citi Research, margins have dropped in recent quarters and improving them could allow companies to meet investors’ ever growing expectations.
“There has been a key difference in margins of late that may not be as evident to many market watchers – operating profit margins have been slipping,” explains Levkovich. This fact has been obscured by climbing after-tax profits, but he says this is because effective tax rates are at their lowest point in years.
Tax rate dropping on S&P 500 Companies
Effective tax rates have been dropping for the last six years, at least for companies on the S&P 500 (INDEXSP:.INX). In 2Q2007 tax rates for the index as a whole were 300 basis points higher than they were in the second quarter of this year. The energy sector is the only major exception, with an effective tax rate around 38 percent, but there are six other sectors with rates under 30 percent.
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S&P 500 earnings impressive
With impressive earning numbers and low effective tax rates, it’s no wonder that margins have been largely ignored by investors. After all attention usually turns to margins either when profits are high and in danger of stagnating or when earnings are dropping and ‘efficiencies’ are the only way to maintain profitability. But in this case improving operational profit margins could serve a third purpose, meeting unrealistic profit expectations with realistic earnings growth. The recent drop in margins suggests that there is room for improvement in at least some sectors.
Unfortunately, falling effective tax rates that covered up the opportunities in improving margins could also wipe those opportunities out by changing course. In fact, Levkovich expects the S&P 500 (INDEXSP:.INX) as a whole to miss on the current consensus.
“Effective tax rates may move a bit higher as well and that development may restrain earnings growth relative to hoped-for outcomes,” explains Levkovich. “The 11% consensus bottom-up EPS growth being forecast for 2014 seems unlikely and the market may be slightly ahead of itself at this juncture.”