The Power of Profit: Business and Economic Analyses, Forecasting, and Stock Valuation

183 Pages·2010·1.38 MB·English

by  Ali Anari

The Power of Profit
·
Ali Anari James W. Kolari
The Power of Profit
Business and Economic Analyses,
Forecasting, and Stock Valuation
123
AliAnari JamesW.Kolari
TexasA&MUniversity TexasA&MUniversity
MaysBusinessSchool MaysBusinessSchool
CollegeStationTX77843 CollegeStationTX77843
USA
USA
[email protected]
[email protected]
ISBN978-1-4419-0648-9 e-ISBN978-1-4419-0649-6
DOI10.1007/978-1-4419-0649-6
SpringerNewYorkDordrechtHeidelbergLondon
LibraryofCongressControlNumber:2009938545
©SpringerScience+BusinessMedia,LLC2010
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ToFaye,Karie,Armita,andWes
Preface
InrecentyearstheUSAandglobaleconomyhavebeenshockedbyfinancialcrises
thatseverelydamagedcreditmarketsandfinancialinstitutions.Theupshothasbeen
unprecedented in post-Great Depression era declines in output, capital stock, and
profitsamongbusinessfirmsaroundtheworld.Criticspointtoavarietyofpotential
culpritstoexplainthecurrenteconomicandfinancialcrises,suchaspoorcorporate
governancemechanisms,excessivemanagementcompensationincentives,short-run
wealthmaximization,irresponsiblefinancialpractices,lackofregulatoryoversight
ofsystemicrisk,andmacroeconomicandmonetarypolicybreakdowns.Naturally,
adebateisemergingabouthowtoinstillmoreprudentmanagementpracticesinan
efforttoavoidrepeatingthecatastrophesofthelastfewyears.Thesedifficulttimes
therefore provide an opportunity to consider new ideas and see whether they are
usefulinbettermanagingbusinesspracticesinthefuture.
This book seeks to contribute to this debate by carefully examining the role of
profit in business firms in particular and the economy in general. It combines the
efforts of a macroeconomist (Ali Anari) and finance professor (James W. Kolari),
who share a common interest in business and economic analysis, forecasting,
and stock valuation. The authors’ previous work experiences in business firms, as
well as consulting and academic research activities, motivated the development
of a profit system model that takes into account interactions between fundamental
business variables, including output, capital stock, profit rate, profit margin, and
totalprofit.Theprofitsystemmodelisatoolthatbusinessfirmscanusetoanalyze
andforecastthesefundamentalvariables.Toourknowledge,nosuchmodelexists
thatintegratestheseimportantbusinessvariables,eventhoughtheyareinextricably
dependent on one another. We believe that the profit system model has many
practical applications tobusinessfirmsandindustries,inadditiontotheaggregate
business sector and national economy. Also, stock investors can utilize the profit
system model for estimating and forecasting the valuation of the stock market as
a whole in addition to individual firms’ stocks. It is our hope that readers will
implementthisnewmodelintheirdailybusinessandinvestmentpracticesandfind
otherinnovativeapplicationsalso.
We would like to thank our editor, Nicholas Philipson, for his enthusiastic
support during this project. We met briefly with him in Houston a few years ago,
explainedthebasicideastohim,andimmediatelygainedafriendwhounderstood
what we were trying to do. Also, we thank Charlotte Cusumano, who provided
editorialassistance.
vii
Contents
1 TheRoleofProfitinAdvancedMarketEconomies . . . . . . . . . . 1
2 Profit System Models of the Firm, Industry,
andBusinessSector . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
2.1 Theoretical Foundation of Profit System Models
oftheFirm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
2.1.1 MathematicalEconomicApproachtoObtaining
aProfitSystemModelofProduction . . . . . . . . . . . . 6
2.1.2 AccountingApproachtoObtainingaProfitSystem
ModelofProduction . . . . . . . . . . . . . . . . . . . . 7
2.1.3 ProfitSystemModelofCapitalStock . . . . . . . . . . . 8
2.1.4 ProfitSystemModelofProfitMargins . . . . . . . . . . . 8
2.1.5 ProfitSystemModelofEmployment . . . . . . . . . . . . 9
2.1.6 Other Key Business Variables: Sales Tax,
Depreciation,TotalEmploymentCompensation,
andWageRate . . . . . . . . . . . . . . . . . . . . . . . 10
2.1.7 ProfitSystemChannelofInflationTransmission . . . . . . 10
2.1.8 ProfitSystemModelsofDeflatedOutput,Deflated
CapitalStock,andDeflatedLaborProductivity . . . . . . 11
2.1.9 TotalProfitEquations . . . . . . . . . . . . . . . . . . . . 12
2.1.10 ProfitSystemEconomicEquilibrium . . . . . . . . . . . . 12
2.1.11 ProfitSystemTheoryofEconomicGrowth. . . . . . . . . 13
2.1.12 ProfitSystemTheoryofBusinessCycles . . . . . . . . . . 14
2.1.13 FinancialSectorVariables:InterestRateandCredit . . . . 15
2.2 EmpiricalProfitSystemModelsintheFormofDynamicEquations 15
2.2.1 GeneralApproach . . . . . . . . . . . . . . . . . . . . . . 15
2.3 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Appendix:GeneralFormoftheExtendedProfitSystemModel
withGoodsandServicesPlusLaborMarkets . . . . . . . . . . . . . . . 26
3 A Macroeconomic Profit System Model of Advanced
MarketEconomies . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
3.1 MacroeconomicProfitSystemModel . . . . . . . . . . . . . . . . 29
3.1.1 BusinessSectorProfitSystemModel . . . . . . . . . . . . 33
ix
x Contents
3.1.2 NonprofitSectorModel . . . . . . . . . . . . . . . . . . . 34
3.1.3 CombinedBusinessSectorProfitSystemModel
andNonprofitSectorModel. . . . . . . . . . . . . . . . . 35
3.1.4 TheMonetaryPolicyModel . . . . . . . . . . . . . . . . 35
3.1.5 DebtModel . . . . . . . . . . . . . . . . . . . . . . . . . 36
3.1.6 MacroeconomicEquilibrium . . . . . . . . . . . . . . . . 36
3.1.7 ChannelsofInflationandMonetaryPolicyTransmission . 37
3.1.8 Wicksell’s Cumulative Process in the
MacroeconomicProfitSystemModel . . . . . . . . . . . 38
3.1.9 TheGovernmentSectorandProfitability . . . . . . . . . . 39
3.2 ApplicationoftheMacroeconomicProfitSystemModel
totheUSEconomy . . . . . . . . . . . . . . . . . . . . . . . . . . 39
3.2.1 Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
3.2.2 EstimationoftheMacroeconomicModel. . . . . . . . . . 44
3.2.3 TestingModelReliability . . . . . . . . . . . . . . . . . . 51
3.3 MonetaryPolicyAnalysisandtheImpactsofEconomic
StimulusPlans . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
3.3.1 MonetaryPolicyAnalysis . . . . . . . . . . . . . . . . . . 61
3.3.2 FiscalPolicyAnalysis . . . . . . . . . . . . . . . . . . . . 62
3.3.3 MacroeconomicPolicyAnalyses:AScenarioApproach . . 63
3.4 BusinessCycleAnalysis . . . . . . . . . . . . . . . . . . . . . . . 69
3.5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
4 ProfitSystemModelsoftheCorporateSector . . . . . . . . . . . . . 81
4.1 CorporateModels. . . . . . . . . . . . . . . . . . . . . . . . . . . 82
4.1.1 TheCorporateModel . . . . . . . . . . . . . . . . . . . . 82
4.1.2 TheNonfinancialCorporateModel . . . . . . . . . . . . . 84
4.2 Data for Estimating Corporate and Nonfinancial
CorporateSectorModels . . . . . . . . . . . . . . . . . . . . . . . 84
4.3 TheEstimatedCorporateProfitSystemModel . . . . . . . . . . . 84
4.4 The Estimated Nonfinancial Corporate Sector
ProfitSystemModel . . . . . . . . . . . . . . . . . . . . . . . . . 86
4.5 StochasticSimulationsoftheEstimatedCorporateModels . . . . . 86
4.6 Out-of-Sample Forecasts of Corporate Profit
SystemModels . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
4.7 A Quarterly Profit System Model of the Nonfinancial
CorporateSector . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
4.8 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92
Appendix: Estimated Nonfinancial Corporate Profit System
ModelUsingQuarterlyDataSeries:1958Q1–2008Q4 . . . . . . . . . . 93
5 ProfitSystemModelsforIndustries . . . . . . . . . . . . . . . . . . . 95
5.1 TheEmpiricalRepresentationoftheModelforIndustries . . . . . 95
5.2 IndustryData . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
Contents xi
5.3 EmpiricalResults . . . . . . . . . . . . . . . . . . . . . . . . . . . 98
5.3.1 Mining,Quarrying,andOilandGasExtraction
(NAICS21) . . . . . . . . . . . . . . . . . . . . . . . . . 99
5.3.2 UtilitiesIndustry(NAICS22) . . . . . . . . . . . . . . . . 100
5.3.3 ConstructionIndustry(NAICS23) . . . . . . . . . . . . . 101
5.3.4 ManufacturingIndustry(NAICS31–33) . . . . . . . . . . 103
5.3.5 WholesaleTradeIndustry(NAICS42) . . . . . . . . . . . 104
5.3.6 RetailTradeIndustry(NAICS44–45) . . . . . . . . . . . 106
5.3.7 Transportation and Warehousing Industry
(NAICS48–49) . . . . . . . . . . . . . . . . . . . . . . . 107
5.3.8 InformationIndustry(NAICS51). . . . . . . . . . . . . . 109
5.3.9 FinanceandInsuranceIndustry(NAICS52) . . . . . . . . 110
5.3.10 Professional and Business Services Industry
(NAICS54–56) . . . . . . . . . . . . . . . . . . . . . . . 112
5.3.11 Education and Health Services Industry
(NAICS61–62) . . . . . . . . . . . . . . . . . . . . . . . 113
5.3.12 Leisure and Hospitality Services Industry
(NAICS71–72) . . . . . . . . . . . . . . . . . . . . . . . 115
5.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116
6 AProfitSystemModelofStockMarketValuation . . . . . . . . . . . 119
6.1 A Profit System Model of the Standard and Poor’s
IndustrialIndex . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
6.1.1 StockMarketPriceIndexes . . . . . . . . . . . . . . . . . 120
6.1.2 DataforStandardandPoorIndustrialIndexFirms . . . . . 122
6.1.3 AProfitSystemModelforStockMarketIndexValuation . 122
6.1.4 Estimated Profit System Model for the S&P
IndustrialIndexFirms . . . . . . . . . . . . . . . . . . . . 124
6.1.5 EstimatingS&P’sIndustrialIndexoftheStockMarket . . 125
6.2 StockMarketCapitalization . . . . . . . . . . . . . . . . . . . . . 130
6.3 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134
7 AProfitSystemModeloftheFirmforBusinessAnalysis
andStockValuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
7.1 ApplicationoftheProfitSystemModeltoFirms . . . . . . . . . . 137
7.1.1 EmpiricalModel . . . . . . . . . . . . . . . . . . . . . . 137
7.1.2 DataIssues . . . . . . . . . . . . . . . . . . . . . . . . . 139
7.2 EmpiricalResultsforTwoUSCorporations . . . . . . . . . . . . . 140
7.2.1 DataforFirms . . . . . . . . . . . . . . . . . . . . . . . . 141
7.2.2 Empirical Results for International Business
MachinesCorporation. . . . . . . . . . . . . . . . . . . . 141
7.2.3 EmpiricalResultsforJohnson&Johnson . . . . . . . . . 147
7.3 FurtherDiscussion . . . . . . . . . . . . . . . . . . . . . . . . . . 151
7.3.1 StrategicBusinessPlanning . . . . . . . . . . . . . . . . . 152
7.3.2 BudgetaryControl. . . . . . . . . . . . . . . . . . . . . . 152
xii Contents
7.3.3 CapitalBudgetingDecisions . . . . . . . . . . . . . . . . 153
7.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
8 ConcludingRemarks . . . . . . . . . . . . . . . . . . . . . . . . . . . 155
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
AbouttheAuthors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169
AuthorIndex . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
SubjectIndex . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
Chapter 1
The Role of Profit in Advanced Market
Economies
Duringourcareersasbusinesseconomistsbeforeenteringuniversityresearchpro-
grams,weobservedthatprofitabilitycriteriaarekeyvariablesnotonlyininvestment
decisionsbutalsoinproductiondecisionsafterinvestmentsaremadeandgoodsand
servicescomeonstream.Profitabilitynotonlydeterminesthelevelofinvestments
butalsothelevelofoutput.Inouracademiccareers,wehavefoundthat,whilethere
isanextensivetheoreticalandempiricalliteratureontherelationshipsbetweenprof-
itabilitycriteriaandcapitalformationactivities,1asmanifestedbyprojectevaluation
courses in universities, scant attention has been paid to the relationships between
profits and production activities after capital formation projects are implemented.
Consequently,amajorgapintheliteratureexiststotheextentthatthepredictiveand
analytic power of profit has not been fully exploited on both the microlevel of the
firmandthemacroleveloftheeconomy.Giventheimportanceofprofitinadvanced
marketeconomies,wherethebulkofnationaloutputisproducedbythebusinessor
for-profitsector,thisbookinvestigateshowprofitmeasurescanbeutilizedtobetter
understand business activities. To exploit the power of profit, we propose a profit
systemmodelofthefirmfoundedonthreepremises:
1. Profit rate determines capital formation investment. At the project evaluation
stage,investmentprojectsareselectedbasedonthefirm’srequiredhurdleratesof
returnoncapital(hereafterprofitrates)toattainthefirm’sobjective.Alternative
firm objectives include profit maximization, sales maximization, and so on,
1Forfurtherdiscussionontheroleofprofitasadrivingforceincapitalformationactivitiesinbusi-
nessfirms,seeSmith(1776),Ricardo(1815),Marx(1867),Schumpeter(1934),Keynes(1936),
Solow(1957),Sraffa(1960),Friedman(1962),Baumol(1974),andSamuelson(1974).Keynes’
(1936)assertionthatinvestmentandemploymentopportunitiesdependonthemarginalefficiency
ofcapitalsparkedsubstantialresearchontherelationshipbetweenrequiredprofitratesandcapital
formation, for example, see neo-Keynesian and neoclassical studies by Jorgenson (1963, 1967,
1971), Hall and Jorgenson (1967), Lucas and Prescott (1971), Abel, Mankiw, Summers, and
Zeckhauser (1989), and Feldstein (1996). Relatedly, the cost of capital is a key determinant of
investmentinmodelsofcapitalformationbasedonTobin’sqratioofthevalueofacompanygiven
byfinancialmarketstoitstotalassets,forexample,seeAlchian(1955),BrainardandTobin(1968),
Tobin(1969),Abel(1979),Summers(1981),Hayashi(1982),Shapiro(1986),andAsimakopulos
(1971,1991).
A.Anari,J.W.Kolari,ThePowerofProfit,DOI10.1007/978-1-4419-0649-6_1, 1
(cid:2)C SpringerScience+BusinessMedia,LLC2010