Want A Better View Of Next Year’s Profit Growth? Meet Average America Inc.

Want A Better View Of Next Year’s Profit Growth? Meet Average America Inc.
Paul Allison, CFA

about 1 year ago7 mins

  • Bottom-up “sell side” market forecasts predict the S&P 500 will grow profit by 5% next year.

  • The “Average America Inc.” approach to forecasting 2023 points to a worse outlook. But its -8.5% forecast is likely closer to what investors actually anticipate.

  • You can take advantage of meaningful market moves in either direction to buy or sell based on AAI’s -8.5% EPS forecast for 2023.

Bottom-up “sell side” market forecasts predict the S&P 500 will grow profit by 5% next year.

The “Average America Inc.” approach to forecasting 2023 points to a worse outlook. But its -8.5% forecast is likely closer to what investors actually anticipate.

You can take advantage of meaningful market moves in either direction to buy or sell based on AAI’s -8.5% EPS forecast for 2023.

Mentioned in story

US stock market valuations have fallen sharply in anticipation of a more difficult year ahead, and whether stock prices improve from here depends a lot on 2023’s profit picture. Top of your to-do list, then, should be forming a view on next year’s profit growth. Done the usual way, that can be an arduous task, so I've devised a novel way to do it…

First, here’s what conventional forecasting tells you.

One way to wrap your head around what’s going to happen next year is to pick off each company in the S&P 500, forecast each one’s prospects, and group all those forecasts together to get an aggregate picture of corporate America. (This is what’s known as a “bottom-up” approach to forecasting.)

But you’re busy, and I’m guessing you have neither the time nor the inclination for that. Luckily, professional “sell-side” stock analysts do this for a living, and market data firms like FactSet take all those forecasts and publish average or consensus estimates. Take a look at the chart below: it shows that for 2023 analysts are expecting S&P 500 earnings per share (EPS) of 232.23, which would be 5% better than this year.

Source: FactSet.
Source: FactSet.

There’s one major problem with using these “guesses”, though. Investors are usually a couple of steps ahead of analysts. That’s because sell-side analysts are prone to waiting for company management to communicate their official views before penning their own forecasts. So the trick, then, is to try and get into the mind of the average investor and get a feel for what they think.

Next, meet Average America Inc. (AAI).

By imagining America’s a single firm with average profit levels, I’ve built an average income statement and used it as a baseline to think through the big cost buckets that will either add to or detract from my forecast for AAI’s revenue growth. We know, of course, that there’s no such thing as a uniform income statement, but I’ve suspended my disbelief, taken the aggregate gross, operating, and net profit margins from CSIMarket’s third-quarter 2022 analysis and built one.

Source: CSIMarket.
Source: CSIMarket.

Let me start with the punchline. By my estimates, the S&P 500 will turn in around 4% sales growth next year, but end up with EPS declining by 8.5%.

Source: Finimize.
Source: Finimize.

What should immediately strike you is this is quite a bit worse than FactSet’s bottom-up 5% growth forecast. But if I’m right, 2023’s profit fall will look more like those from all the so-called earnings recessions dating back to World War II – they saw an average 13% decline. Take a look at my hypothetical income statement:

Source: Finimize.
Source: Finimize.

Let’s break this down…

Sales: expect 4% growth

Our journey down the income statement starts here. US companies have – so far – been successfully passing along cost increases to their customers. In fact, the latest analysis from research firm Yardeni shows that revenues look set to grow 12% this year, comfortably outstripping inflation. My best guess is that 2023 follows a similar pattern, and I’m pegging sales growth at the OECD’s latest forecast for US 2023 inflation: 3.9%.

Signpost: most Big Tech firms are currently expected to do better than 4%, with Microsoft (MSFT), Amazon (AMZN), and Alphabet (GOOG/GOOGL) all expected to grow sales closer to 10%, according to Koyfin’s estimates. And tech giants make up a lot of the S&P 500 – more than 20% if you include Tesla (TSLA).

Cost of Goods Sold (COGS): expect 7% growth

COGS are costs that directly feed into the manufacture of goods or the providing of a service. They range from raw materials that go into making things to the salaries of workers directly employed in the manufacturing process. On average, though, COGS make up around 55% of American firms’ sales.

Signpost: gross margins (sales minus COGS as a percentage of sales) performed much better than expected in the latest set of quarterly earnings as American firms passed their cost increases on to customers. But firms tend to feel the pain of rampant cost inflation on a time lag, as most have contracts that lock in prices, at least for a while. This means that at least some of the increase in commodity costs – shown by the chart of the iShares Diversified Commodity Swap UCITS ETF (ticker: ICOM; expense ratio: 0.19%) – will cause a hangover for next year.

Source: Blackrock iShares.
Source: Blackrock iShares.

With my finger firmly in the air, I’m estimating COGS will outpace sales and grow by 7% next year, which would cause gross profit to inch up only 0.3%

Operating costs: expect 4% growth

Operating costs aren’t directly linked to the production of goods or services. The biggest buckets tend to be salaries for marketing and sales workers, as well as advertising, and research and development costs.

Signpost: a large proportion of these expenses are variable – they move up and down in line with sales growth. Wage inflation has tracked general inflation tightly this year and there’s no reason to expect it’ll be different next year. So I’m plugging in operating cost growth of 4%, in line with sales growth. This higher level of expenses takes a big bite out of gross profit, though, and would see 2023 operating profit falling 5%.

Interest and Taxes: expect 4% growth

There’s a lot of focus on interest rates this year, but for most firms interest is a small percentage of sales. Using the average level of indebtedness (measured using net debt to earnings before interest, taxes, depreciation, and amortization, or EBITDA) and a rough estimate of what interest rates firms pay, even a tripling of rates on the outstanding debt would lift interest to just 0.9% of sales, from the previous 0.3%.

Signpost: even though interest payments are only a tiny percent of sales, they – and taxes – are fixed in nature and so can put a dent in bottom-line growth. Assuming a 4% uplift in these expenses – which roughly aligns with a tripling of interest costs – that takes operating profit growth of -5% down to -10% for net income.

Bottom line: expect net income -10%

So if you take these numbers together, what you’re left with at the end of your income statement journey is -10% growth. Now, buybacks over the last 10 years have propped up EPS growth by around 1 percentage point, and US firms will probably step up their buyback efforts to support EPS. So you could expect EPS of around -8.5%. A far cry from the conventional forecasts’ 5% growth.

Here’s why AAI is useful.

The most obvious conclusion from this analysis is that corporate profits look set to fall by more than analysts' current forecasts. Still, I’d caution against any auto-reflex reach for the sell button. Remember: actual investors tend to be a bit ahead of analysts, and they’re likely expecting some fall in profits next year.

You could use this framework as a starting point for your own decision-making. If you’re inclined to think that corporate America will perform better than AAI, you could add to your US stock positions, and an exchange-traded fund like the Vanguard S&P 500 ETF (VUSA/VUAG; 0.03%) is a diversified way to do just that. On the other hand, if you’re pessimistically inclined, and think AAI is destined for an uglier fate, then you could do the exact opposite and sell US holdings or even buy the S&P 500 Inverse Daily Swap UCITS ETF (SPXTS; 0.5%), which is designed to go up when the S&P 500 falls.

Perhaps, though, the best course of action is to wait for the market to move meaningfully in one direction or another. If, for example, the S&P 500 falls 10% from here, and you feel that the assumptions and forecasts laid out in this analysis are still valid, then that could be a nice opportunity to buy.



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