Why perfectly efficient markets have profits
Profit Margins, Cost of Capital and Capital Intensity
I often see a lot of people on the internet have quite a lot of misunderstanding and skewed views of basic economics, and few things are as misunderstood as “Market Efficiency”.
Today we’re going over a common misconception around perfectly efficient markets that nonetheless keeps propping up over and over again.
The Misconception
The misconception is quite simple, and I would wager that many people, even those well versed in economic theory might make the same mistake.
It is most well exemplified in the following quote:
In a perfectly efficient market, profit margins trend towards zero.
This is often accompanied by some example of a company or groups of companies having “high” profit margins, and a subsequent complaint about cartels, monopolies, oligopolies and a call to action demanding regulators do more to “correct” this perceived market ineficiency.
Occasionally some well meaning person will point out the barriers to entry as a reason for those high margins, perhaps pointing out the role of the state and regulators in imposing and maintaining those barriers, and the conversation will wind up side tracked.
Rarely I see anyone make the correct argument however.
That is, rarely do I see someone arguing that those profit margins are not just the result of lack of competition, but are in fact a necessary and inevitable result of the accurate and efficient allocation of capital.
Yes that’s right.
In well-functioning efficient markets, profit margins are not supposed to trend towards zero.
This isn’t an uncommon misconception either, and you’re not alone! Just look at this poll I made on Twitter a couple of weeks ago:
I suspect that my followers tend to be more savvy of economics than the average person, but they too made the same mistake!
We’re all human, and we all make mistakes at the end of the day!
The Reality
In a perfectly efficient and highly competitive market profit margins do not trend towards zero, instead their “target” profit margin changes on a company by company basis, and depends on a combination of capital intensity and cost of capital.
Only in a world where both the capital intensity required to operate the business is zero, or the cost of that capital is zero, is the target profit margin for a specific company zero.
This does raise some questions though, doesn’t it?
The first is… What is capital intensity?
The simplest explanation of capital intensity is the answer to a very simple question:
What is the point with the highest ratio of earnings generated by capital employed that is achievable by the company? What is the amount of revenue and capital employed at that point?
In other words, if you were to divide the Earnings Generated by the Capital Employed, at different levels of Revenue and its corresponding required capital, what would be the highest value?
The reason we are looking for the highest value is simple, it’s because that is the sweet spot where economies of scale are maximizing the productive capacity of every dollar being employed in the business.
This means that this is the optimal scale at which the company should operate, and so any less/more Revenue, or any less/more capital would result in higher costs and therefore higher profit margin requirements.
Another question (which is often ignored) is… What is cost of capital?
This has been discussed at length in many other blog posts, and I won’t get into the intricacies of it here, so I will simply quote you the definition that the corporate finance institute provides:
Cost of capital is the minimum rate of return that a business must earn before generating value. Before a business can turn a profit, it must at least generate sufficient income to cover the cost of the capital it uses to fund its operations. This consists of both the cost of debt and the cost of equity used for financing a business.
The easiest way to calculate what the cost of capital is, is by simply looking at the other available options with the same (or more attractive) risk profile.
For example, it is common to use the US treasury bond rate as a cost of capital proxy, since it is a “risk-free” asset that provides a return.
To that, investors add a variable amount of basis points according to the risk profile characteristics of the investment in question.
A very simplified formula determining the cost of capital of a given investment would be something like:
Cost of Capital = US T-bond Rate + Equity Risk Premium + Country Risk Premium + Volatility Risk Premium
You can add additional parameters, including industry risk premiums, fraud and solvency risks, etc…
At the end of the day, cost of capital is the cost you’re paying to have cash allocated to keeping a business up and running.
When you put these 2 things together it becomes obvious why profit margins cannot trend towards zero!
Even if we assume that the business is operating in its maximally capital efficient manner, we still have to pay for the cost of that capital in order to operate.
And those costs must come from profits unless we are fully financing the business with debt… In which case we still must have sufficient excess profits to pay off the interest payments (which are often less flexible and therefore leave the business in a more vulnerable position).
The main difference between financing with debt or equity here is primarily one of determining who gets the “profits” rather than determining their necessity, though there are indeed some benefits to using debt, such as a reduced tax burden.
A Simple Example
Let us imagine a small business that sells gravel which it acquires by mining a small gravel pit.
Let’s also assume that all around it are hundreds of other gravel pits each offering the exact same product, and that both you and every other gravel pit operate to their peak efficiency in what is a highly competitive market.
You can think of this as the textbook example of an “efficient market”.
Will the profit margin for this small business with a gravel pit be close to zero?
No!
Let’s pretend like the most effective point for the business in terms of the ratio between earnings generated and capital utilized is the following:
Revenue - $50
Capital Utilized - $100
Additionally let’s pretend the cost of capital, once we account for all the risks and alternatives available is 5%.
This means that for this company to operate at maximum efficiency it has a cost of capital of $5, and so its profit margin will trend towards 10%.
That is, the company requires at least 10% profit margins in order to be a worthwhile investment, when it is operating in the most effective manner that it can.
If we raised the cost of capital to 10% we get a different required margin:
Revenue - $50
Capital Utilized - $100
Cost of Capital - 10%
Minimum Required Profit
$100 * 10% = $10
Minimum Required Profit Margin
$10 / $50 = 20%
We can fiddle with these numbers in other ways too, for example if we change the amount of capital utilized:
Revenue - $50
Capital Utilized - $20
Cost of Capital - 5%
Minimum Required Profit
$20 * 5% = $1
Minimum Required Profit Margin
$1 / $50 = 2%
Or if we change the amount of revenue generated:
Revenue - $200
Capital Utilized - $100
Cost of Capital - 5%
Minimum Required Profit
$100 * 5% = $10
Minimum Required Profit Margin
$10 / $200 = 5%
With these examples it’s easy to see that unless the capital required or the cost of capital is 0, then the result will always be some amount of minimum required profit, and that profit must always come from the revenues that were generated.
Since each company has different costs of capital, as well as different ratios and scales at which they operate in the most efficient manner, each individual company will have their own individual Minimum Required Profit Margin, even if they are operating in a highly competitive environment.
Additionally it’s important to note that we are looking at revenues here, and costs will necessarily increase with those revenues.
In many ways Revenues on it's own is a bad way of measuring capital intensity, and the better way would really be some form of earnings because it includes the inherent costs of generating that revenue.
I wanted to simplify things so that it would be more understandeable, and so I scrapped that additional complexity in favor of a simpler mental model.
This necessarily means that the profit margins of the market as a whole will trend towards an equilibrium point in which the optimum amount of companies will be operating in the market, with the exact margins determined primarily by the capital intensity and cost of capital of the industry as a whole.
I hope you’ve learned something today!
And the next time you see someone make this same mistake in their reasoning, send them to this post so that they too can understand where their understanding led them down the wrong path.
Until next time!