Data Update 7 for 2025: The End Game in Business!
The Bottomline for Business
I am in the third week of the corporate finance class that I teach at NYU Stern, and my students have been lulled into a false sense of complacency about what's coming, since I have not used a single metric or number in my class yet. In fact, we have spent almost four sessions (that is 15% of the overall class) talking about the end game in business. In an age when ESG, sustainability and stakeholder wealth maximization have all tried to elbow their way to the front of the line, all laying claim to being what business should be about, I have burnished my "moral troglodyte" standing by sticking with my belief that the end game in business is to maximize value, with earnings and cash flows driving that value, and that businesses that are profitable and value creating are in a much better position to do good, if they choose to try. In this post, I will focus on how companies around the world, and in different sectors, performed on their end game of delivering profits, by first focusing on profitability differences across businesses, then converting profitability into returns, and comparing these returns to the hurdle rates that I talked about in my last data update post.
Profitability - Absolute and Relative
While we may all agree with the proverbial bottom line being profits, there seems to be no consensus on how best to measure profitability, either from an accounting or an economic perspective. In this section, I will begin with a simplistic breakdown of the income statement, the financial statement that is supposed to tell us how much a business generated in profits in during a period, and use it as an (imperfect) tool to understand the business economics.
While accountants remain focused on balance sheets, with a fixation of bringing intangibles on to the balance and marking everything up to the market, much of the information that we need to assess the value of a business comes from income and cash flow statements. I am not an accountant, but I do rely on accounting statements for the raw data that I use in corporate finance and valuation. I have tried my hand at financial statement analysis, as practiced by accountants, and discovered that for the most part, the analysis creates more confusions than clarity, as a multiplicity of ratios pull you in different directions. It is for that reason that I created my own version of an accounting class, that you can find on my webpage.
During the course of the class, I assess the income statement, in its most general form, by looking at the multiple measures of earnings at different phases of the statement:
Which of these represents the bottom line for businesses? If you are a shareholder in a company, i.e., an equity investor, the measure that best reflects the profits the company made on the equity you invested in them is the earnings per share. That said, there is information in the measures of earnings as you climb the income statement, and there are reasons why as you move up the income statement, the growth rates you observe may be different:
To get from net income to earnings per share, you bring in share count, and actions taken by companies that alter that share count will have effects. Thus, a company that issues new shares to fund its growth may see net income growth, but its earnings per share growth will lag, as the share count increases. Conversely, a company that buys back shares will see share count drop, and earnings per share growth will outpace net income growth.
To get from operating income to net income, you have multiple variables to control for. The first is taxes, and incorporating its effect will generally lead to lower net income, and the tax rate that you pay to get from pretax profit to net income is the effective tax rate. To the extent that you have cash on your balance, you will generate interest income which adds on to net income, but interest expenses on debt will reduce income, with the net effect being positive for companies with large cash balance, relative to the debt that they owe, and negative for firms with large net debt outstanding. There is also the twist of small (minority) holdings in other companies and the income you generate from those holdings that affect net income.
To get from gross income to operating income, you have to bring in operating expenses that are not directly tied to sales. Thus, if you have substantial general and administrative costs or incur large selling and advertising costs or if you spend money on R&D (which accountants mistakenly still treat as operating expenses), your operating income will be lower than your gross income.
Finally, to get from revenues to gross income, you net out the expenses incurred on producing the goods/services that you sell, with these expenses often bundled into a "cost of goods sold" categorization. While depreciation of capital investments made is usually separated out from costs of goods sold, and shown as an operating cost, there are some companies, where it is bundled into costs of goods sold. In many cases, the only statement where you will see depreciation and amortization as a line item is the statement of cash flows.
With that template in place, the place to start the assessment of corporate profitability is to to look at how much companies generated in each of the different earnings metrics around the world in 2024, broken down by sector:
For the financial services sector, note that I have left revenues, gross profit, EBITDA and operating profit as not applicable, because of their unique structure, where debt is raw material and revenue is tough to nail down. (Conventional banks often start their income statements with net interest income, which is interest expense on their debt/deposits netted out against net income, making it closer to nough to categorize and compare to non-financial firms). I have also computed the percentage of firms globally that reported positive profits, a minimalist test on profitability in 2024, and there are interesting findings (albeit some not surprising) in this table:
On a net profit basis, there is no contest for the sector that delivers the most net income. It is financials by a wide margin, accounting for a third of the net profits generated by all firms globally in 2024. In fact, technology, which is the sector with the highest market cap in 2024, is third on the list, with industrials taking second place.
As you move from down the income statement, the percentage of firms that report negative earnings decreases. Across the globe, close to 84% of firms had positive gross profits, but that drops to 67% with EBITDA, 62% percent with operating income and 61% with net income.
Across sectors, health care has the highest percentage of money-losing companies, on every single metric, followed by materials and communication services, whereas utilities had the highest percentage of money makers.
While looking at dollar profits yields intriguing results, comparing them across sectors or regions is difficult to do, because they are in absolute terms, and the scale of businesses vary widely. The simple fix for that is to measure profitability relative to revenues, yielding profit margins - gross margins for gross profits, operating margins with operating profits and net margins with net profits. At the risk of stating these margins, not only are these margins not interchangeable, but they each convey information that is useful in understanding the economics of a business:
As you can see, each of the margins provides insight (noisy, but still useful) about different aspects of a business model.
With gross margins, you are getting a measure of unit economics, i.e., the cost of producing the next unit of sale. Thus, for a software company, this cost is low or even zero, but for a manufacturing company, no matter how efficient, the cost will be higher. Even within businesses that look similar, subtle differences in business models can translate into different unit economics. For Netflix, adding a subscriber entails very little in additional cost, but for Spotify, a company that pays for the music based on what customers listen to, by the stream, the additional subscriber will come with additional cost. Just to get a big picture perspective on unit economics, I ranked industries based upon gross margin and arrived at the following list of the ten industries with the highest gross margins and the ten with the lowest:
With the caveat that accounting choices can affect these margins, you can see that the rankings do make intuitive sense. The list of industry groups that have the highest margins are disproportionately in technology, though infrastructure firms (oil and gas, green energy, telecom) also make the list since their investment is up front and not per added product sold. The list of industry group with the lowest margins are heavily tilted towards manufacturing and retail, the former because of the costs of making their products and the latter because of their intermediary status.
With operating margins, you are getting a handle on economies of scale. While every companies claims economies of scale as a rationale for why margins should increase as they get larger, the truth is more nuanced. Economies of scale will be a contributor to improving margins only if a company has significant operating expenses (SG&A, Marketing) that grow at a rate lower than revenues. To measure the potential for economies of scale, I looked at the difference between gross and operating margins, across industries, with the rationale that companies with a large difference have a greater potential for economies of scale.
Many of the industry groups in the lowest difference (between gross and operating margin) list were also on the low gross margin list, and the implication is not upbeat. When valuing or analyzing these firms, not only should you expect low margins, but those margins will not magically improve, just because a firm becomes bigger.
The EBITDA margin is an intermediate stop, and it serves two purposes. If provides a ranking based upon operating cash flow, rather than operating earnings, and for businesses that have significant depreciation, that difference can be substantial. It is also a rough measure of capital intensity since to generate large depreciation/amortization, these companies also had to have substantial cap ex. Using the difference between EBITDA and operating margin as a measure of capital intensity, the following table lists the industries with the most and least capital intensity:
Profit margins by industry: US, Global, Emerging Markets, Europe, Japan, India and China
Again, there are few surprises on this list, including the presence of biotech at the top of the most capital intensive list, but that is due to the significant amortization line items on their balance sheets, perhaps from writing off failed R&D, and real estate on the top of the least capital intensive list, but the real estate segment in question is for real estate operations, not ownership.
The net margin, in many ways, is the least informative of the profit margins, because there are so many wild cards at play, starting with differences in taxes (higher taxes lower net income), financial leverage (more leverage reduces net margins), cash holdings (interest from higher cash balances increases net income) and cross holdings (with varying effects depending on how they are accounted for, and whether they make or lose money). Ranking companies based upon net margin may measure everything from differences in financial leverage (more net debt should lead to lower margins) to extent of cross holdings and non-operating investments (more of these investments can lead to higher margins).
Accounting Returns
While scaling profits to revenues to get margins provides valuable information about business models and their efficacy, scaling profits to capital invested in a business is a useful tool for assessing the efficiency of capital allocation at the business., The two measures of profits from the previous section that are scaled to capital are operating income (before and after taxes) and net income, with the former measured against total invested capital (from equity and debt) and the latter against just equity capital. Using a financial balance sheet structure again, here is what we get:
The achilles heel for accounting return measures is their almost total dependence on accounting numbers, with operating (net) income coming from income statements and invested capital (equity) from accounting balance sheets. Any systematic mistakes that accountants make (such as not treating leases as debt, which was the default until 2019, and treating R&D as an operating expense, which is still the case) will skew accounting returns. In addition, accounting decisions to write off an asset or take restructuring charges will make the calculation of invested capital more difficult. I wrote a long (and boring) paper on the mechanics of computing accounting returns laying out these and other challenges in computing accounting returns, and you are welcome to browse through it, if you want.
If you are willing to live with the limitations, the accounting returns become proxies for what a business earns on its equity (with return on equity) and as a business (with the cost of capital). Since the essence of creating value is that you need to earn more than your cost of capital, you can synthesize returns with the costs of equity and capital that I talked about in the last post, to get measures of excess returns:
I have the data to compute the accounting returns for the 48,000 publicly traded companies in my sample, though there are estimation choices that I had to make, when computing returns on equity and capital:
Thus, you will note that I have bypassed accounting rules and capitalized R&D and leases (even in countries where it is not required) to come up with my versions of earnings and invested capital. Having computed the return on capital (equity) for each company, I then compared that return to the cost of capital (equity) to get a measure of excess returns for the company. In the table below, I start by breaking companies down by sector, and looking at the statistics on excess returns, by sector:
Note that across all firms, only about 30% of firms earn a return on capital that exceeds the cost of capital. Removing money-losing firms, which have negative returns on capital from the sample, improves the statistic a little, but even across money making firms, roughly half of all firms earn less the the cost of capital.While the proportions of firms that earn returns that exceed the cost of equity (capital) vary across sectors, there is no sector where an overwhelming majority of firms earn excess returns.
I disaggregate the sectors into industry groups and rank them based upon excess returns in the table below, with the subtext being that industries that earn well above their cost of capital are value creators (good businesses) and those that earn below are value destroyers (bad businesses):
Excess returns by industry: US, Global, Emerging Markets, Europe, Japan, India and China
There are some industry groups on this list that point to the weakness of using last year's earnings to get accounting return on capital. You will note that biotech drug companies post disastrously negative returns on capital but many of these firms are young firms, with some having little or no revenues, and their defense would be that the negative accounting returns reflect where they fall in the life cycle. Commodity companies cycle between the most negative and most returns lists, with earnings varying across the cycle; for these firms, using average return on capital over a longer period should provide more credible results.
Finally, I look at excess returns earned by non-financial service companies by sub-region, again to see if companies in some parts of the world are better positioned to create value than others:
As you can see, there is no part of the world that is immune from this problem, and only 29% of all firms globally earn more than their cost of capital. Even if you eliminate firms with negative earnings, the proportion of firms that earn more than their cost of capital is only 46.5%.
Implications
I have been doing versions of this table every year for the last decade, and the results you see in this year's table, i.e., that 70% of global companies generate returns on equity (capital) that are less tan their hurdle rates, has remained roughly static for that period.
Making money is not enough for business success: In many businesses, public or private, managers and even owners seem to think that making money (having a positive profit) represents success, not recognizing that the capital invested in these businesses could have been invested elsewhere to earn returns.
Corporate governance is a necessity; Marty Lipton, a renowned corporate lawyer and critic of this things activist argued that activist investing was not necessary because most companies were well managed, and did not need prodding to make the right choices. The data in this post suggests otherwise, with most companies needing reminders from outside investors about the opportunity cost of capital.
Companies are not fatted calves: In the last few years, two groups of people have targeted companies - politicians arguing that companies are price-gouging and the virtue crowd (ESG, sustainability and stakeholder wealth maximizers) pushing for companies to spend more on making the world a better place. Implicit in the arguments made by both groups is the assumption that companies are, at least collectively, are immensely profitable and that they can afford to share some of those spoils with other stakeholders (cutting prices for customers with the first group and spending lavishly on advancing social agendas with the second). That may be true for a subset of firms, but for most companies, making money has only become more difficult over the decades, and making enough money to cover the cost of the capital that they raise to create their businesses is an even harder reach. Asking these already stretched companies to spend more money to make the world a better place will only add to the likelihood that they will snap, under the pressures.
A few months ago, I was asked to give testimony to a Canadian legislative committee that was planning to force Canadian banks to lend less to fossil fuel companies and more to green energy firms, a terrible idea that seems to have found traction in some circles. If you isolate the Canadian banks in the sample, they collectively generated returns on equity of 8.1%, with two thirds of banks earning less than their costs of equity. Pressuring these banks to lend less to their best customers (in terms of credit worthiness) and more to their worst customers (green energy company are, for the most part, financial basket cases) is a recipe for pushing these banks into distress, and most of the costs of that distress will be borne not by shareholders, but by bank depositors.
YouTube Video
Data Updates for 2025
Data Update 4 for 2025: Interest Rates, Inflation and Central Banks!
Data Update 6 for 2025: From Macro to Micro - The Hurdle Rate Question!
Data Links
Excess returns by industry: US, Global, Emerging Markets, Europe, Japan, India and China
Profit margins by industry: US, Global, Emerging Markets, Europe, Japan, India and China
Paper Links
Great stuff. Made me think. When govt tries to pick winners they will make life worse for everyone.