In practice, reported profits fluctuate widely. Table 1.1 shows business profits for a well known sample of 30 industrial giants: those companies that comprise the Dow Jones Industrial Average. Business profit is often measured in dollar terms or as a percentage of sales revenue, called profit margin, as in Table 1.1. The economist’s concept of a normal rate of profit is typically assessed in terms of the realized rate of return on stockholders’ equity (ROE). Return on stockholders’ equity is defined as accounting net income divided by the book value of the firm. As seen in Table 1.1, the average ROE for industrial giants found in the Dow Jones Industrial Average falls in a broad range of around 15 percent to 25 percent per year. Although an average annual ROE of roughly 10 percent can be regarded as a typical or normal rate of return in the United States and Canada, this standard is routinely exceeded by companies such as Coca-Cola, which has consistently earned a ROE in excess of 35 percent per year. It is a standard seldom met by International Paper, a company that has suffered massive losses in an attempt to cut costs and increase product quality in the face of tough environmental regulations and foreign competition.
Some of the variation in ROE depicted in Table 1.1 represents the influence of differential risk premiums. In the pharmaceuticals industry, for example, hoped-for discoveries of effective therapies for important diseases are often a long shot at best. Thus, profit rates reported by Merck and other leading pharmaceutical companies overstate the relative profitability of the drug industry; it could be cut by one-half with proper risk adjustment. Similarly, reported profit rates can overstate differences in economic profits if accounting error or bias cause
investments with long-term benefits to be omitted from the balance sheet. For example, current accounting practice often fails to consider advertising or research and development expenditures as intangible investments with long-term benefits. Because advertising and research and development expenditures are immediately expensed rather than capitalized and written off over their useful lives, intangible assets can be grossly understated for certain companies. The balance sheet of Coca-Cola does not reflect the hundreds of millions of dollars spent to establish and maintain the brand-name recognition of Coca-Cola, just as Merck’s balance sheet fails to reflect research dollars spent to develop important product names like Vasotec (for the treat-ment of high blood pressure), Zocor (an antiarthritic drug), and Singulair (asthma medication). As a result, business profit rates for both Coca-Cola and Merck overstate each company’s true economic performance.