Corporate profit margins are thought to have risen to pre-crisis levels, part of the bull case for US equities, but this picture underestimates the impact that taxes will have on the bottom line even if consensus growth estimates turn out to be accurate.
“Corporate profitability is perceived to be at record levels even as eight of the 10 S&P 500 sectors are generating EBIT margins below their 2007 highs and investors do not fully comprehend the impact of lower effective tax rates on EPS,” writes Citi analyst Tobias Levkovich. “While top-line growth is likely to be achieved in 2014, which then can drive operating leverage, some of the earnings benefit will be chipped away by probable tax rate increases.”
Corporate profit margins: Effective taxes are expected to rise
While Levkovich would normally project 4% EPS growth for every 1% of GDP growth, he thinks that a combination of fully utilized net operating loss carry-forwards, accelerated depreciation write-offs, and domestic profits reaching a 35% statutory tax rate will result in higher effective tax rates for many domestic companies.
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“While top-line growth should create operating earnings leverage and bump up EBIT margins, not all of it will reach the bottom line,” he writes. “Thus, EPS is only expected to rise by less than 7% this year and Street estimates are easing back already to reflect guidance changes.”
Looking at EBIT margins instead of after tax profit margins shows a strikingly different picture of the recovery, with margins not only below their pre-crisis levels but lower than they were in 2010 and trending flat. Healthcare and consumer staples EBIT margins have fallen off the most, with healthcare margins continuing to drop.
Corporate profit margins; CAPE doesn’t account for everything: Levkovich
The upside to this is that even though Levkovich is pulling back on his EPS growth forecasts and expects other analysts to do the same, he argues that strong credit conditions normally prevent margins from falling. Levkovich still considers the 2013 multiple expansion to have been a catchup to the historical average, bringing prices back in line with earnings not overshooting them, and he thinks that CAPE arguments don’t adequately account for inflation, normalized bond yields, or equity risk premium, so even with weaker EPS growth he argues that there is plenty of ‘give’ in the market to accommodate.