Sunday, October 4, 2009

The Land of Outrageous Profits! - Part 1

Welcome to America! The Land of Outrageous Profits! Our companies are so rich that people have time to complain about how rich they are. Michael Moore, after making millions through the quasi capitalist system, has made a recent movie about how horrible capitalism is. Protesters at the G-20 conference complain about the horrible things a capitalism has done. And my personal favorite is when people complain about the evils of WalMart or Exxon or any other Big Bad Company. The reason it is my favorite is because most of what they say is wrong, meaningless, or both. And they don't even have a clue that they are wrong, meaningless, or both.

So, to begin let me give some disclosure about myself. I have never taken an economics class in my life, neither high school nor college. I have not read an economics textbook, ever. The same with Finance. In fact the only business classes that I had was a Management for Non-Business majors in college. So who am I to talk about business, finance, and investing? Well, I started seriously learning about investing in 4th grade and have closely followed the US stock markets since then. Pictures of myself in my early years show that I understood money was important as early as 2 years old. My parents can testify that I started analyzing complex money issues (with my allowance) and was much better at saving during my teen years than my bothers. In high school, I started to learn and follow the commodity markets.

In college I started investing the money I had. Since that time I have invested in a variety of things. I have made money investing in stocks, bonds, and real estate. I have also owned and operated an S corporation with some college friends. Each of my investing endeavors has contributed to my education about money and finances. Do I consider myself an expert? Not by a long shot, but I feel confident in explaining the basics.

Before I get too far, let's go over Rule #1 of business: The primary goal of all businesses is to make money for the owners. This rule is what distinguishes businesses from charities. While all businesses play a political/social game of saying that safety or the customer or employees or something else is most important, they are not. All of these other factors are weighed against making money. For instance, safety may be important. If a company has a dangerous job to do, it has several options:
1) Allow the company to do the job without mitigation of the danger.
2) Provide extra safety equipment or training to the employee.
3) Compensate the employee at a higher rate for taking the risk.
4) Decide not to do the job.
In each case, the company has weighed the cost of injury (medical, bad publicity, wages, etc.) to the benefit of the job being completed (increased efficiency, prestige, etc.). For businesses, all decisions are financial. Some people aren't comfortable with that concept. (Even the most "socially conscious" businesses make their decisions based on money.) Now that we have Rule #1 out of the way, let's get on with it.

First, let's look at how big some of these companies are, after all, we are told that Big "Insert BoogeyMan Here" are the cause of our problems. I'll use the Dow Jones Industrial Index as an example. Thirty large cap stocks make up this index. While the overall diversity is lacking (it has improved in the last decade), the index has been a very close approximation of the market as a whole (the market being made up of 5000+ publically traded stocks).

Three ways of looking at the size of company give different results. First, revenue. This is the total amount of sales of goods and services that a company has. The top five in the DOW are Exxon ($477 billion - a perennial favorite bad guy), Walmart ($405 billion -another favorite), Chevron ($273 billion - part of the Big Oil Cartel), GE ($182 billion - usually you don't hear too much bad about them because everyone thinks they are an manufacturing company - actually, almost half of their business is in the financial services sector), and finally Bank of America ($124 billion - does anyone not think this company is the embodiment of Satan by now). So clearly, those companies who bring in a lot of money are evil, evil, EVIL!!!!

Oh, wait, I am suppose to be for capitalism. So, let me say, none of these companies are evil. In an effort of full disclosure, I own a large amount of Walmart stock. I also own all five of these companies through various retirement funds and ETFs. The major reason why these five large companies bring in so much money (notice I said bring in, not make) is because they sell products or services that millions use. Oil and gas are the fuel of our economy. Walmart is the middle & low class shopping haven, GE has their hands in so many things you can't not buy GE products, and we all like to keep our money safe in a bank.

Second, market capitalization. This is the value of the stock that has been issued. The top five are: Exxon ($319 billion), Microsoft ($222 billion), Walmart ($189 billion), Proctor & Gamble ($165 billion), and JP Morgan Chase ($164 billion). Two are the same but three are different although all have been villified to some degree or another. Another way of describing market capitalization is the perceived value of the company by investors. This perceived value includes the sum of assets and liabilities, as well as the future earnings potential based on past experience, market conditions, and personnel the company has. Market capitalization is the most fluid of the three valuation types because it flucuates whenever the stock is being traded.

Third, earnings. This is the actual money that is earned (and thereby taxed) by the company. The top five are: Exxon ($82 billion), Chevron ($43 billion), Walmart ($21 billion), AT&T ($20 billion), Microsoft ($20 billion). A lot of the same characters, now we have AT&T (communications giant). Earnings are a sign of how companies have used resources, labor, technology, and capital to accomplish Rule #1.

All of these lists are in absolute numbers. The 30 DOW stocks combined had a market capitalization of $3.2 trillion, revenue of $2.8 trillion, and earnings of $374 billion. Now a lot of the criticism that companies get is due to people not understanding how financials work together. Some are focused on only a small component (Walmart's low wages or lack of health insurance, Exxon's "largest profits in history", Microsoft's monopolistic practices, even AT&T not limiting use of its phone lines). The common theme is that these companies are making billions in earnings and should be using them for something else.

The earnings that I mentioned above are before taxes. A large chunk of this is used to pay taxes. The corporate tax rate in the US is 35% . Now because of different tax laws and where the companies "earned" the money, they may be paying more or less than this. The top five earners of the DOW paid the following amounts in income taxes in 2008: Exxon - $36.53 billion, Chevron - $19.03 billion, Walmart - $7.15 billion, AT&T - $7.04 billion, Microsoft - $5.25 billion.

For those of you who are math challenged, even though the corporate tax rate in the US is 35%, Exxon and Chevron (those oil companies who do nothing for us) are paying out 45% of their taxable earnings in income taxes. (Most of this is due to the number of other governments that they paid income taxes to and the various tax liability in those locations). Take Exxon for a moment, $36.53 billion in income taxes. $3.8 billion of that went to the US or state governments. The rest went to governments of other countries. Before anyone cries foul, only $10 billion of the $82 billion in earnings was related to operations in the US. So, $3.8 billion is rather fair. What it more interesting is that of the $477 billion in revenue, $121 billion was from US operations. Basically, what this tells me is that operations outside the US are far more efficient at generating earnings (10/121 = 8.2% for US vs 72/356= 20% for international). So, even though there is effectively a higher tax on the earnings outside of the US (3.8/10=38% vs. 32.73/72=45%), because of the increased efficiency in generating earnings, the majority of operations occur outside of the US. Furthermore, any expansion of operations would make more sense to be outside the US since that maximizes income. In other words, if the US wanted to lure more of the operating dollars to the US (thereby being able to tax them), they would have need to lower the corporate income tax rate (I'll have to write another post on that one!).

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