Today's Financial Times Lex column contains an interesting article arguing that US corporate profit margins are far above their long-run average and should "return to the mean relatively quickly", implying significant risk to current consensus earnings estimates. The article states that corporate profits before depreciation, tax and interest amounted to about 35% of corporate output in the second quarter compared with an average since 1947 of 29%.

On closer inspection, however, the margins measure used appears somewhat odd, in that pre-depreciation profits are compared with net corporate output, i.e. after deducting depreciation. That is, there seems to be an inconsistency in the treatment of depreciation between the numerator and denominator of the ratio.

Two consistently-defined measures of profit margins are 1) profits before depreciation, tax and interest as a percentage of gross corporate output, i.e. before deducting depreciation, and 2) and profits before tax and interest as a percentage of net output. These gross and net measures are shown in the first chart. The gross measure behaves similarly to the series used in the FT article but net margins are currently much less extreme relative to history – 19.4% in the second quarter versus an average since 1950 of 18.1%.

The widening gap between the two measures reflects a trend increase in depreciation as a proportion of output, related to a rising economy-wide capital-output ratio and a shortening average life-span of capital goods. If gross margins were to mean revert, as Lex thinks likely, net margins would fall to the bottom of their historical range.

Economic theory suggests that the income share of capital-owners should be stable over the long run but this refers to their rewards after compensation for the erosion in value of assets due to depreciation. This argues for using net rather than gross margins.

The FT analysis focuses on domestic profits, ignoring the 25% share of total profits accounted for by foreign earnings. The second chart compares total profits net of taxes and adjusted for inflation with a log-linear trend. This suggests that profits were 8% below trend in the second quarter after a 10% first-quarter shortfall – similar to the 13% deviation at the bottom of the last recession.

The slope of the trend-line implies real profits growth of about 3.5% per annum. Assuming 2% inflation, nominal trend profits will be about 18% above the second-quarter actual level by the end of 2010. Consensus hopes of a significant earnings recovery next year are therefore not irrational, providing a near-term economic pick-up can be sustained.