(Un)Happy Returns

Are excess corporate profits driving inflation?

This week’s post, building on last week’s about interest rates and inflation, was driven by this headline from yesterday’s Telegraph:

Which in turn builds on a narrative outlined in this piece from the Guardian in March:

So a clear story - that a big part of our inflation problem is coming not from companies putting prices up to reflect their own increasing costs, but instead by companies pushing up prices even harder than their cost increases would require and feathering their own nests in doing so. Damn those fat cats.

Except this runs so counter to the experience I have talking to business leaders around the country who are, frankly, racing to survive in a world of rising costs, labour shortages, Covid debts and subdued demand that it warranted a closer look at the numbers.

And doing so took me right back to shouting at the radio in the 1990s.¹

Let’s consider a thought experiment. I’m offering you the opportunity to invest £100 in my business, and in return I’m offering you a return of £10 a year. Are you interested? Well, depending on how believable you find my business plan, it is at least an attractive financial offering, I think.

Let’s vary the terms a bit, though. Now I need £1000 of investment from you, but in return I’m offering you a handsome profit of £25 a year. Still interested?

After all, I’ve upped the profit on the deal by 2.5 times, haven’t I?

It probably didn’t take you long, though, to spot the catch - £25 as a return on a £1000 investment is not nearly as good as £10 on an investment of £100. In other words, it is the rate of return that is important, not the absolute return.

And more than that, in the context of analysing a business’s performance, we don’t just have to be careful to analyse a rate of return, we also have to be careful to consider what we are measuring the rate of return on. In other words, what is the denominator of our fraction.

Consider this illustration. My business did £1m of sales and recorded £200k of profit for the year. Not only is £200k a nice amount of money, but it looks like a pretty good “return on sales” of 20%. Nothing to complain about there.

Except there is another bit of information that matters. I had to invest £50m in building the factory and buying the machinery that allowed me to make those sales in the first place. And if all I’m ever going to get from my £50m is £200k per year, that doesn’t look like a particularly smart investment.

There’s the rub, and here is the explanation of the difference between our headlines and the actual experience of people running businesses at the moment. When talking about profit margins, “return on sales” is only one measure of success and a very partial one at that. What really matters, and what defines whether setting the business up in the first place was worthwhile or not, is “return on capital employed” or “return on investment”. How much cash did I have to put in, and how much am I getting out?

The Guardian article listed above refers to a study by the Union Unite. It seems like a fairly well researched piece, but what it is reporting is that the return on sales of the FTSE350 companies it analysed is higher than it was in 2019. But what about the denominator that matters - capital employed? Surely as businesses stock up post pandemic and spin up their operations again, that figure has moved too?

Well, yes it has. For a more definitive version of what’s going on, we can turn to the government’s key data source, the ONS. Their regular reporting of the profitability of UK companies gives us this chart:

Now at last we are looking at the right denominator - this chart measures return on capital for UK non-financial businesses, and shows that if anything rates of return remain depressed versus medium term history. Incidentally, this version of the chart includes oil and gas companies who’s inflated returns have been very obvious over recent quarters - the version excluding them is even more clearly flatlining.

So what’s the conclusion? Well, it does indeed seem to be the case that returns on sales are rising, as are absolute profits. But the driver for that is, at least in part, a big increase in the capital (and therefore cash) tied up in those businesses - the ONS figures when examined in detail show that the lower return on capital in recent periods is made up of higher profits but offset by much higher capital employed.

That may indeed, therefore, be a driver of inflation at some mathematical level, but instead of “Corporate fatcats driving greedflation excesses”, the duller but more accurate conclusion is probably “prices driven higher as companies try to fund stock rebuilding and capital investment programmes which were held back in lockdown”.

Not quite so clickbait-y, but that’s the price we pay for accuracy.

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1. In those days, the BBC Radio 4 Today programme made a regular habit every quarter of running outrage pieces about how BT had made “£x00 per SECOND!” without ever considering how their profit figure related to the capital employed in an entire country’s telecoms network.