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How can business leaders make better production and capital investment decisions? How can Wall Street analysts improve their predictions of future stock market values? How can government improve macroeconomic forecasts and policies? In The Power of Profit, Anari and Kolari demonstrate how profit measures can be applied as the basis for these and many other applications of economic, policy, financial, and business analysis. The underlying theme of the book is that profitability is the driving force in free market economies. Firms invest in capital, produce goods and services, and generate sales in an effort to reap profits. Firms that are unprofitable exit the marketplace and are replaced by profitable firms. Despite the crucial importance of profits, however, there is no formal model that directly relates profits to capital formation and output. Previous studies over the past 100 years on profit and the economy are mainly descriptive in nature, without any well-specified model grounded in microeconomic theory. Filling this gap, the authors present a profit system model of the firm grounded in basic accounting relationships in addition to the well-known Cobb-Douglas production function, which can be applied to individual firms, industries, and the business sector as a whole.

Through rigorous data analysis, the authors show how the profit system modelcan be applied to:

modeling the U.S. business sector and national economy

forecasting output, capital stock, total profit, profit rates, and profit margins

examining the relationships among profitability, economic growth, and the business cycle

simulating the effects of potential monetary policy changes on the business sector and national economy

valuing the Standard & Poor’s stock market index as well as individual firms.

The result is a model that integrates microeconomic and macroeconomic factors and that can be widely applied in business and economic decisions, policymaking, research, and teaching.

Inhaltsverzeichnis

Frontmatter

Chapter 1. The Role of Profit in Advanced Market Economies

During our careers as business economists before entering university research programs, we observed that profitability criteria are key variables not only in investment decisions but also in production decisions

after

investments are made and goods and services come on stream. Profitability not only determines the level of investments but also the level of output. In our academic careers, we have found that, while there is an extensive theoretical and empirical literature on the relationships between profitability criteria and capital formation activities

Ali Anari, James W. Kolari

Chapter 2. Profit System Models of the Firm, Industry, and Business Sector

This chapter proposes an integrated profit system model of the firm consisting of dynamic relationships among fundamental business variables. The first part of the chapter derives theoretical profit system models of production, capital stock, profit rate, profit margin, total profit, and employment for firms in the business sector, in addition to related models of employee compensation and other business variables. The second part of the chapter provides empirical profit system models that capture the relationships between these variables as a system of dynamic equations. These empirical models can be applied to individual firms, industries, and the whole business sector.

Ali Anari, James W. Kolari

Chapter 3. A Macroeconomic Profit System Model of Advanced Market Economies

This chapter provides a two-sector macroeconomic model consisting of a business sector and a nonprofit sector. This profit system model is developed from the microprofit system model of the firm in Chapter 2. Using annual US macroeconomic data in the period 1959–2008, the empirical representation of the model is estimated, its reliability is tested, and different applications are investigated, including economic forecasting, monetary policy, fiscal policy, and business cycle analysis. In brief, the results demonstrate the crucial role of profits in the economy. Profit drives not only business sector and national output but is a prime determinant of capital stock and employment. Given the major influence of profits on the economy, it is not surprising that it also plays a role in the transmission of inflation. Moreover, we show that changes in profit can lead to business cycle fluctuations in economic activity.

Ali Anari, James W. Kolari

Chapter 4. Profit System Models of the Corporate Sector

This chapter applies the profit system model to the US corporate sector. The US corporate sector produced more than 75 percent of the output of the US business sector and about 60 percent of the US GDP in recent years. Like the aggregate business sector model in Chapter 3, estimated corporate sector models can be used for (1) forecasting the volumes of output and capital stock as well as profit rates, profit margins, and aggregate profits in the corporate sector; (2) macroeconomic policy analysis; and (3) business cycle analysis. However, here we focus on the aggregate profit of the corporate sector. The aggregate profit of the corporate sector is a crucial variable because its level and growth rate have important implications for market economies. Higher growth rates of aggregate corporate profits suggest that more business investments are passing the market tests of profitability. The historical simulation of aggregate corporate profit provides insights into its long-run path based on the values of fundamental variables, such as sales, capital stocks, profit rates, and profit margins. When aggregate corporate profit is discounted using an appropriate capitalization rate, the result is the total market valuation of aggregate corporate stocks. Chapter 6 extends the analyses to this stock market application.

Ali Anari, James W. Kolari

Chapter 5. Profit System Models for Industries

In this chapter profit system models are developed for US industries. Our purpose is to estimate profit system models for different industries and use the estimated models for out-of-sample forecasts of key business variables. Industry analyses are popular in benchmarking exercises that compare individual firms’ performance to its industry. Also, industry analyses can reveal important trends that will affect individual firms. We report profit system results for the following industries: Mining, Quarrying, and Oil and Gas Extraction (NAICS 21), Utilities (NAICS 22), Construction (NAICS 23), Manufacturing (NAICS 31–33), Wholesale Trade (NAICS 42), Retail Trade (NAICS 44–45), Transportation and Warehousing (NAICS 48–49), Information (NAICS 51), Finance and Insurance (NAICS 52), Professional and Business Services (NAICS 54–56), Education and Health Services (NAICS 61–62), and Leisure and Hospitality (NAICS 71–72). Due to data restrictions, the scope of our analyses is limited to the period 1987–2007, with forecasts covering the period 2008–2011.

Ali Anari, James W. Kolari

Chapter 6. A Profit System Model of Stock Market Valuation

As discussed in previous chapters, our profit system model provides estimates and forecasts of total profits for both individual firms and groups of firms. Here we consider its application to groups of firms with stock prices that are aggregated into a general stock market price index. First, we use our model to generate in-sample estimates and out-of-sample forecasts of the total profits of corporate firms in a stock market index. Second, since corporate firms’ profits are available to shareholders, discounting these aggregate profits by an appropriate rate of return gives the present value of total profits. This present value represents an estimate of the intrinsic or underlying value of the stock market index. It is important to note that our stock market valuation model depends on profit system model estimates and forecasts of total profits. This approach is consistent with the long-standing and popular discounted cash flow(DCF) approach to stock market valuation.

Ali Anari, James W. Kolari

Chapter 7. A Profit System Model of the Firm for Business Analysis and Stock Valuation

As discussed in Chapter 2, dynamic relationships exist between sales (output), profit, profit rate, profit margin, and capital stocks of firms – that is, the values (magnitudes) of these fundamental variables in any period depend on the current and past values of the other variables. Consequently, for purposes of business analysis, an integrated business model of firms must contain all the dynamic relationships among these variables. Our profit system models in Chapter 2 provide analytical frameworks for short-run and long-run analyses of these fundamental variables over time. Here we apply the profit system model to individual firms for business analysis, forecasting, and stock market valuation. Regarding stock market valuation, we integrate the profit system model and the popular discounted cash flow (DCF) stock valuation model to perform in-sample analyses and out-of-sample forecasts of individual firms’ stock values.

Ali Anari, James W. Kolari

Chapter 8. Concluding Remarks

The famous economist Knut Wicksell defined economics as a practical science. Viewing the business world around us, we can see that modern market economies are comprised of a for-profit or business sector and a nonprofit sector. Practitioners in the business sector make investment and production decisions based on the fundamentals of expected and realized profit rate, profit margin, and total profit. In this book we presented a practitioner model of the firm in the sense that the model is derived from the definitions of profit rate and profit margin, which are well-known concepts among business people. With these concepts in hand, we defined output as the product of the profit rate and the market value of capital stock divided by profit margin. Similarly, capital stock was defined as the product of output and profit margin divided by profit rate.

Ali Anari, James W. Kolari

Backmatter

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