People who have some basic knowledge of the stock market are generally aware that corporate earnings and interest rates are key determinants that influence the stock market. I’ll try to focus this column primarily on what impacts earnings.
At the most basic level earnings are revenues minus expenses. For a company to do well it can either increase sales, or control expenses, though preferably it will do both.
There are several ways a company can increase sales. It can develop a new product or technology, it can increase market share, and it can expand into new markets.
Sales are also influenced by the overall health of the economy. For more cyclical businesses, such as automakers and home builders the health of the overall economy has a much greater impact on sales versus food companies.
When looking at the change in revenues for a company it is important to differentiate between the growth in sales due to pricing versus units sold. If a company is showing a 3% increase in sales, which is just due to inflation, that is not impressive, because there is 0% unit growth. If the 3% increase in sales was due to an increase in units sold in a flat pricing environment that would be more significant.
While sales are a key driver of earnings, companies also need to be aware of expenses. That is why it is important to focus on the profit margins for a company. Some companies might be good at increasing sales, but if profit margins are weak that is not helping overall earnings.
All businesses have labor expenses. In recent years labor costs have been increasing at a relatively low rate. In some industries where there is more a scarcity of workers with specific skills labor costs are increasing at a faster rate. In addition health care costs have been increasing at a faster rate than wages.
Companies that manage to increase worker productivity can better absorb an increase in labor costs. In recent years productivity improvements have been fairly anemic, which is a key reason, as to why both wage growth and profit growth have been rather weak.
The cost of materials is the other key component that has a significant impact on the cost structure of companies in general. These costs can be highly variable, since they are often commodities, which can be subject to major price swings on a year by year basis.
Companies also must factor in the cost of rent and utilities in their operations. In a high cost market, such as our local area this is oftentimes a major issue for businesses. That has sometimes been a reason for some companies deciding to leave California and go to other lower cost states.
For some companies interest expense can be significant. The current low interest rate environment has been quite favorable for companies who need to fund their operations with debt.
The political and regulatory environment also impacts the cost structure for corporations. The United States has essentially the highest corporate tax rate in the developed world, however, most companies are not paying the stated rate due to loopholes. This has resulted in many corporations having operations overseas to take advantage of lower taxes.
For many investors who just invest in various funds it is not necessary to know about the profit trends of specific companies or industries. However, this analysis is still applicable in determining the overall level of profitability for our entire economy.
In essence because our economy is growing fairly slowly that is causing overall revenue growth to be fairly modest, though increased foreign operations have boosted sales for many corporations. American business has done quite well at managing costs, but labor costs are starting to increase, and unless there is a boost in productivity that could limit future profit growth.
On balance should expect earnings and stock prices to continue to increase over time. However, the pace of earnings growth will likely be less in the future than what we have experienced in prior periods.