Data Update 6 for 2026: In Search of Profitability!
The Business End Game Clarified!
Crass and mercantile though this may sound, the end game for a business is to make money, and a business that fails this simple test cannot survive for long, no matter how noble its social mission, how great its products and how much it is loved by its customers and employees. In this post, I start with a defense of this mercantile objective, and argue that attempts to expand it to incorporate social good leave both businesses and societies worse off. I look at business profitability, first in absolute terms in 2025, and then relative to revenues, examining why profit margins vary across businesses and sectors. I then raise the ante and argue that making money is too low a standard to hold companies to, since the capital invested in these companies can generate returns elsewhere, opening the door to bringing in the opportunity costs (costs of equity and capital) that I introduced in my last post.
The Business End Game
In 1970, Milton Friedman argued in a New York Times article that the social responsibility of a business is to deliver (and increase) profits. That view has come under attack in recent decades, but even in the immediate aftermath of the article’s appearance, there was some push back. Some came from people who argued that Friedman was missing details, with a few noting that it is cashflows, not earnings, that businesses should focus on, and others arguing that it is profits over the long term, not just immediate profits, that should be the focus of a business. My guess is that Professor Friedman would have agreed on both fronts, arguing that he was talking about economic, not accounting, profits, and that there was nothing in his mission statement that foreclosed a focus on long term profits.
In the decades since, there has been a more fundamental critique of the Friedman business end game, coming from those who believe that his view is far too cramped and narrow a vision for a business, and that businesses have obligations to society and the planet that need to be incorporated into decision-making. Initially, these critics argued for imposing social and environmental constraints on the profitability objective, and while Friedman may have taken issue with some of these constraints, arguing that that is what laws and regulations should be doing, he would (probably) have gone along with most of them, given real world frictions. Later, though, these critics decided to go for the jugular, arguing that the business objective itself be reframed to include these broader responsibilities, with some arguing for stakeholder wealth maximization, where businesses seek to maximize value to their different stakeholders (employees, lenders, customers). That idea gained traction among some academics, many of whom never grappled with putting this objective into practice in real businesses, and among some CEOs, who realized that being accountable to everyone effectively meant being accountable to no one, but I am not a fan. About two decades ago, stakeholder wealth maximization was supplemented by ESG, an acronym that quickly got buy-in from the establishment. In 2020, when I first looked at ESG, it was at the height of its allure, with investment managers (led by Blackrock), consultants (with McKinsey up front) and academics, all pushing for its adoption. Given the broad buy in, I expected to see clear and conclusive evidence that ESG was not just good for investors and businesses, but also for society, and I was disappointed on every front. The alpha that was attributed to ESG in investing was accidental, coming almost entirely from its overload on tech stocks in its early years, the evidence that ESG helped businesses deliver higher growth and profits was laughably weak, and on almost every societal dimension that ESG was supposed to make the world a better place, it had failed. Even on risk, the one dimension where a rational argument can be mounted for companies following the ESG rulebook, its impact was hazy, with no discernible effects on costs of capital and only anecdotal (and mostly ex-post) evidence for protecting against reputational and catastrophic risks. In the last five years, ESG has fallen out of favor, largely undone by its own internal inconsistencies, but the gravy train that lived off its largesse has moved on, and taken much of what filled the ESG space, repackaged it, and renamed it sustainability. While advocates for sustainability try to create distance between ESG and sustainability, in my (biased) view, much of that discussion is akin to painting lipstick on a pig and then debating what shade of lipstick suits the pig best, rather than attempting to create real change.
It is with intent, therefor, that I named these three forces - stakeholder wealth maximization, ESG and sustainability - the theocratic trifecta in a post that I wrote three years ago, and argued that they failed for the same reasons.
First, by rooting themselves in virtue rather than in business sense, they rendered a disservice to their own cause. After all, once you decide that you are on the side of goodness, any critics of what you do, no matter how well merited their criticism might be, are quickly consigned to the badness heap, and not just ignored, but also reviled for lacking moral fibre. The problem, of course, is that if an action makes business sense (increases profitability and value), you would not need a virtue brigade to push for that action in the first place. Second, by leaving the definitions of their central ideas (stakeholder wealth, ESG and sustainability) amorphous, they made it easier to sell to investors and companies, but at the expense of consistency and focus. In my 2022 post on ESG, where the Russian invasion of Ukraine had forced its defenders to morph in the face of evidence that that world was more dependent on fossil fuels and defense companies than they had been willing to concede in earlier years, I noted the loss of credibility that comes from shifting definitions of goodness. Third, and most critically, in their zeal to push these concepts to a wider audience and get more people to buy in, they sold a lie, i.e., that you can be good (whatever that definition of good may be) without sacrifice. I have no idea whether ESG and sustainability salespeople meant what they said when they argued that investors could earn higher returns, by adding ESG constraints to their portfolios, and that companies could become more profitable, if they incorporated environmental and social considerations into decision making, but my categorization of people in these spaces as either useful idiots or feckless knaves stems from a refusal to face up to the inherent trade offs.
After decades of pushback from critics of the Friedman business end game, I, for one, believe that Milton Friedman was right, and that we would all be better off to follow up and ask the question of what can be done, given that businesses are profit-seekers, to advance social good and curb externalities. I don’t believe that the disclosure route, which seems to have become the fallback for some seeking better business behavior, will accomplish much, and it may do more harm than good. While laws and regulations can provide a partial fix, they are blunt instruments, and in a setting where businesses can move easily across borders, they may not be effective. Ultimately, we (as consumers and voter) get the businesses we deserve, and if after paying lip service to social causes, we buy products and vote for governments hat undercut those causes, no acronym or word salad will repair the breach.
Profitability in Businesses
I meant to have a short lead-in on why profitability matters at businesses, but as you can see from the previous section, I did get side tracked, but the underlying message is that making money is central to business success and survival, and that measuring profitability is therefore a necessary part of assessing business success and value.
Economic versus Accounting Profits
The Friedman view on the business endgame may have been driven by a vision of economic profits, but in the real world, we are dependent on accounting measures of profits, which are, at best, imperfect substitutes for economic profits. The table below looks at an accounting income statement, highlighting the many measures of profits - gross, operating and net - that you will find in it:
Each profit measure has utility, with gross profits reflecting unit economics, the difference between gross and operating profits capturing economies of scale and the difference between operating and net profits being driven by taxes and choices that businesses make on debt and non-operating assets. In 2025, looking at the aggregate values (in millions of US $) for these line items across sectors, here are the numbers, for both global firms and just the US subset:
In the aggregate, global firms generated $6.2 trillion in net income and $7.7 trillion in operating income on revenues of $72.4 trillion, in 2025; during the same year, US firms generated $2.2 trillion in net income and $2.9 trillion in operating income on revenues of $22.7 trillion in revenues. Across sectors, and looking at revenues, industrials carried the most weight for the global sample, but health care generated the most revenues across the US sub-sample.
Profits scaled to Revenues - Profit Margins
The problem with dollar profits is that comparisons across companies, industries or sectors are skewed by scale differences, and one simple scalar for earnings is revenues, yielding variants of profit margins. While you are undoubtedly familiar with these margin variants, their real use in analysis is in providing insight into business models:
I am not a believer in financial ratio analysis, but I do believe that the income statements for companies, especially examined over time, give us insight into their business models and can help frame valuation narratives. In the table below, I look at differences in margins across sectors in 2025, again looking across global firms, and just US firms:
I have estimated margins, by sector, using the aggregated dollar values for profits and revenues from the previous table, and also reported the cross sectional distribution of company-level margins. Comparing the aggregated margin with the median margin across the sector should give you a sense of how top-heavy the sector is in terms of profitability. In technology, which has the highest weighted operating margin (24.7%) of across sectors, the median operating margin is only 3.41% (-0.30%) across global (US) technology firms; the bigger tech companies are money machines in a sector that still contains a lot of younger and smaller money-losing firms. Note that the margins are not computed for financial service firms, since revenues are often unreported (and mostly meaningless) and gross and operating profits don’t have the same measurement value as they do for non-financial service firms.
Industry Margins and the AI Threat
Breaking down sectors into industries provides more granular detail, and there is a link at the bottom of this post that reports the margin statistics, by industry group. At the risk of stating the obvious, there are large disparities on margins across industries, reflecting differences in unit economics, economies of scale and leverage, as can be seen in this table that lists the industry groupings with the highest and lowest aggregated operating margins among US firms:
At one end of the spectrum, you have industry groups like basic chemicals, which has an aggregated (median) gross margin of 9.31%, making the margin hill much steeper to climb, since operating margins and net margins will be lower. At the other end of the spectrum, in addition to tobacco and railroads (surprised, right?), you have system and application software, delivering an aggregated gross margin of 71.72%, operating margin of 33.21% and net margins of 25.49%, capturing the strong unit economics that characterize the business.
While high margins are a desirable feature for a business, these same high margins can make a business vulnerable to disruption, and the AI sell off that we have seen play out in the last few months in software reflects the concerns that investors have of AI putting significant downward pressure on software margins. If your pushback is that the drop off in revenues and margins has not happened yet, and that it is unfair to software firms to mark their market pricing down preemptively, this is exactly what markets are supposed to do, and these software companies benefited earlier in their lives, when market prices were marked up well ahead of the run-up in margins. You live by the sword (expectations of growth and high margins), you die by it (expectations that growth rates will hit a cliff and margins will decline)!
Time Trends in Profits
I have tracked profit margins for companies for a long time (about three decades) in my datasets, and there is clear evidences that they have trended upwards during the period. In the graph below, I look at the net profit margins for the S&P 500 in the aggregate in this century (from 2000-2025):
As you can see, net profit margins have climbed over the last two decades for US companies, with a number of stories competing for why.
The most cynical explanation is that this increase in margins is all sleight-of-hand, where accountants are pushing through changes, aided and abetted by accounting rule-writers, to make companies look more profitable. As someone who has taken issue with the gaming of earnings that you often see at companies, I am disinclined to take this criticism seriously, since many of the changes in accounting rules (such as the expensing of stock-based compensation and R&D) should push earnings down, and accountants have more power to move income across periods than they do to increase the level of income.
A second explanation is that the macroeconomic environment makes it easier for companies to deliver profits, and this explanation had resonance when interest rates were at historic lows in the last decade. As rates have risen back to more normal levels and the economy limps along, I am skeptical of the reasoning in this explanation.
A third explanation, and this one has been eagerly adopted by many on the political left, is that that this reflects the increase in bargaining power for capital, relative especially to labor, implying that the increase in profits are coming primarily at the expense of worker wages. While there are certainly pockets of the economy where this is true, the margins for most manufacturing and service businesses, which have the highest employee count and wage costs, have stagnated or decreased over the last 20 years, indicating that neither capital nor labor has benefited at least in these sectors.
The fourth, and in my view the most salient rationale for margin increases, is that the composition of the market has changed, as technology companies supplant old-economy companies, bringing superior unit economics and economies of scale to play. Put simple, a market that gets the largest portion of its value from tech companies will deliver much higher margins that one that gets much of its value from manufacturing and service businesses.
Should we concerned that margins may compress in the future? Of course, and we always should, but that compression, if it happens, will depend almost entirely on how the economy performs and the effects of disruption, if it is coming, for tech companies.
Value Creation in Business
If we define the threshold for business success as generating profits, we are setting the bar too low for a simple reason. Starting a business requires capital, and that capital can earn a return elsewhere on investment of equivalent risk. If those words sounds familiar, it is because I used them in my last post on hurdle rates to describe the costs of equity and capital. Thus, value creation requires a business to generate a return on its equity (capital) that exceeds its cost of equity (capital). That is a simple proposition, and a powerful one, but the measurement challenge we face is in determining the returns that companies generate, and for better or worse, we are dependent on accounting measures of these returns. A good way to see what an accounting return is measuring or at least trying to measure is to look at returns on equity and invested capital in a financial balance sheet:
While accounting returns are widely used in practice, as a gauge of investment quality, they can be skewed not just by accounting inconsistencies but efforts by accountants to do the “right thing” (like writing off bad investments. I have laid out my concerns in exhaustive and incredibly boring detail in this paper on accounting returns, which is dated, but still relevant. I summarize the factors that can cause accounting returns on equity and capital to deviate from reality in the picture below:
With those concerns about accounting returns in place, I computed the accounting returns on equity and invested capital for all of the companies in my global sample (48.156 firms) and my US sample (5994 firms), and the following table reports the statistics for both groups, by sector:
Again, I report the accounting returns computed based on aggregated values first, and then the distributional statistics (first quartile, median, third quartile) for the company-level accounting returns. As with profit margins, you can see that even in sectors where the aggregated accounting returns are high (such as technology and communication services), the median value reflects the reality that most companies in these sectors struggle to deliver double-digit returns.
Turning back to our value creation metric, where we compare accounting returns to costs of equity and capital, you have to be consistent, comparing equity returns to equity costs and capital returns to capital costs
The excess return is a numeric, but as with all numbers in business, it is worth looking behind the number at its drivers, i.e., why do some business deliver returns that consistently outstrip their costs of equity and capital, whereas others struggle? The most powerful explainer of excess returns is not qualitative, since the capacity to generate excess returns comes from barriers to entry and competitive advantages. In the language of value investing, it is the width (strength of competitive advantages) and depth (sustainability of competitive advantage) of moats that determine whether a company can earn more than its cost of equity or capital:
If you are interested in this topic, and it is a fascinating one, Michael Mauboussin brings his erudition and knowledge into play in this Morgan Stanley thought piece from October 2024.
Since I have estimates of costs of equity and capital for each of my firms (see my last data update for details), I compute excess returns, by sector, for my global and US samples:
Given what you saw in the last table, with accounting returns, you should not be surprised to learn that only 29% (28%) of global firms earn returns on equity (capital) that exceed their costs of equity (capital). In fact, if you raise the threshold and look at companies that generate 5% or more as excess returns, the numbers drop off to 19% (17%) for equity (capital) excess returns. Most companies have trouble earning their costs of equity and capital, but if you look at the aggregated values, there are multiple sectors in the US (technology, consumer goods and communication services) that earn double digit excess returns, pointing again to larger companies within these sectors being able to set themselves apart from the rest.
If your concern is that the global statistics are being skewed by regional differences, I compute the excess return statistics broken down by region:
As you can see, there is not a single geography where more than 50% of firms earn more than their required returns, with Japan ranking highest in percentages and Canada and Australia the lowest. Here again, the aggregated values tell a different story, with US companies collectively delivering excess returns of 8.44% on equity and 1.81% on capital, suggesting again that large US companies carry the weight of value creation in the market.
Given how much time we spend in finance examining investments and developing decision rules (NPV>0, IRR>Hurdle rate) that are supposed to protect businesses from taking “bad” investments, you may be surprised at the prevalence of value destroying investments. Some of the failure at businesses to deliver returns on capital that exceed the cost of capital may reflect imperfections in our accounting return measures, since it is based upon earnings in the most recent year, and that may bias us against young and growing companies building up to scale. In my book on corporate life cycle, I highlight how accounting returns shift as companies go from youth to decline
:
To see if this is a factor in our global findings on excess returns, I break companies down by age into deciles and compute excess returns across these groupings:
The table broadly reflects what you should expect to see, with a corporate life cycle, as the percent of companies that beat their cost of capital increase as companies age, but the aggregated excess returns peak in middle age (the middle of the life cycle), more pronounced with US than global firms.
A Profitability Wrap Up
Looking at the data, and there is a danger here that I am overreaching, it seems to me that over the last four decades, moats have crumbled, partly as a result of global competition and partly because of disruption (which upends businesses, turning good businesses to bad ones), and the business landscape has tilted more decisively to larger firms, as more and more businesses become winner(s)-take-all. It is in this context that I take a more jaundiced view of what AI will do for company profitability and value. I believe that, as a disruptor, it will cause downward pressure on margins at most firms, and increase the advantages that larger firms have in each business. How do I reconcile this view with the happy talk of AI as a tool that will make companies more productive, and that the resulting lower costs will make them more profitable? Unless the AI tools that you are talking about are exclusive to these companies, in the sense that competitors cannot buy the same or equivalent tools, these AI tools will lower costs across the board, and competition will then kick in on the pricing front, lowering profitability. If that sounds like a reach, I would recommend a revisit of the US retail sector over the last three decades, as online retail, initially viewed as a boon by brick-and-mortar retail firms, ended up destroying most of them and reducing the margins for retail collectively. As consumers, we will benefit, but as investors or employees in the disrupted companies, we will pay a price that outweigh the benefits, for a sizable number of us. I do think that the AI disruption will be more akin to a slow-motion car wreck, in terms of its effect on overall profitability, and that the margin slippage will occur over time, but it will damaging. Time will tell!
YouTube Video
Datasets
Paper on Accounting Returns (Long and Boring)
Data Update Posts for 2026
Thanks prof. I agree. In addition to "winner takes all", I believe growth is rarer now, than it was before. Therefore, everyone is chasing growth.
Great work, as always 👏👏👏👏