Estimating Aggregate Operating Profit Margin for the Next Year

Introduction

Operating profit margin is to be estimated to estimate financial performance of companies, industries and stock market. At the stock market level aggregate operating profit margin is an input into estimating earnings per share.

Sidney R. Finkel and Donald L. Tuttle researched the topic of aggregated profit margin and published their results in the paper “Determinants of Aggregate profit Margin" in Journal of Finance, December 1971 (pp.1067-1075).

They hypothesized that the following four variables determine the aggregate profit margin.

Capacity utilization rate

Unit labor costs

Rate of inflation

Foreign competition

Evaluation of Capacity Utilization

A positive relationship between the capacity utilization rate and the profit margin is expected.

This is because, if production increases as a proportion of capacity, there is a decrease in per-unit fixed production costs and fixed financial costs.

This relationship may not be linear, as at very high rates of capacity utilization operating diseconomies are introduced as firms are forced to use marginal labor and/or some of the older plant and equipment to reach higher capacity utilization.

Reilly and Brown point out that capacity utilization (C.U.) had a peak of 87% in 1978 to a trough of 64% in 1982. It once again reached as peak of 83 percent in 1994 and 1997 and then it went down to less than 70 percent during the recession years 2001-02. The capacity utilization may go down due cyclical downturn in demand and any additions to capacity in the interim will also take it down.

Evaluation of Unit Labor Cost

The change in unit labor cost (labor cost per unit of output) is a cumulative effect of two variables.

1. Changes in wages per hour and

2. Changes in worker productivity

Wages costs per hour increase every year in varying amounts. There is an increase in worker productivity also because of advances in technology. The amount of increase or decrease in unit labor cost depends on the combined effect.

If unit labor costs increase in a period operating margins will come down.

Negative relation

Evaluation of Inflation

Finkel and Tuttle argued in favor of a positive relationship between inflation and the profit margin. According to them, companies can increase prices and thereby raise profit margins. But others argue that expecting all companies to increase prices and on aggregate earn higher margins may be an acceptable idea. To earn higher margins, firms have to increase prices at a greater rate than increase in price level. Hence, the relation cannot be determined from theoretical view but needs to be found out empirical evidence.

Foreign Competition

Finkel and Tuttle contend that export markets are more competitive and export sales are made at a lower margin. This implies exports decrease profit margins.

In contrast, Peter Gray in a comment on the Finkel and Tuttle’s paper felt that reduction in exports and increase in imports could have an important negative impact on the operating profit margin because they influence the selling price of all competing domestic products. The argument of Gray that reduction in exports accompanied by an increase in imports can depress profit margins leads to the idea that reduction in exports and reduction in imports are good profit margins. Thus an increase in foreign trade in either way results in decrease of margins. Reilly and Brown made the conclusion that even this is better treated as an empirical issue.

Empirical Analysis by Reilly and Brown

Reilly and Brown analyzed the data for the period 1977 to 2002 to find the empirical relationship between aggregate margins and determinants.  

They found that relationship between OPM and C.U.R. was always significant and positive and the relationship between OPM and unit labor cost was always negative and significant. 

The rate of inflation and foreign trade variables were never significant in the multiple regression. 

The simple correlation between the profit margin and inflation was consistently negative.

Estimating the Operating Profit Margin

One has to concentrate on the CUR for the economy and the rate of change of in unit labor costs. The trends in these variables can be easily identified at the two extremes of the business cycle. 

At the end of economic recession the capacity utilization rate will be very low. 

Therefore, during the early stages of an economic recovery, there should be large increase in capacity utilization as firms increase production and sales.

At the same time, workers will not be asking for large wage increases.

As production increases, there will be strong increases in labor productivity.

As a result unit labor cost will increase very slowly (or could decline).therefore, as a result of an increase in capacity utilization and a very small increase (or a decline) in unit labor cost, there should be a large increase in operating profit margin. 

In contrast, at the peak of the business cycle, firms will be operating at full capacity, so there will be very small increases or possibly declines in capacity utilization going forward. 

 Due to inflation and expected inflation, there will be large wage increases and any decrease in labor productivity due to decrease in capacity utilization will lead to major decreases in operating profit margin.

How do you estimate operating margins for the next period?

Try to estimate the direction of change in capacity utilization and unit labor costs. This is based on where the economy is in business cycle.

References

Reilly, Frank F., and Keith C. Brown (2006), Investment Analysis and Portfolio Management, 8^th Edition, Thomson South Western, (Main text for the series of revision articles on Security Analysis)

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