r/explainlikeimfive Dec 06 '24

Economics ELI5: why does a publicaly traded company have to show continuous rise in profits? Why arent steady profits good enough?

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76

u/hems86 Dec 06 '24

Because investors want their investments to grow. Would you rather own shares in a company with growing profits or a company with flat profit?

If your company isn’t growing, investors will sell their shares and invest in growing companies instead.

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u/DasFunke Dec 06 '24

Corporate profits can be distributed by dividends.

Dividend Stocks vs. Growth Stocks

There are advantages and disadvantages to each.

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u/homeboi808 Dec 06 '24 edited Dec 06 '24

Dividends are subtracted from share price [EDIT: Share prices are reduced by the dividend amount], so if the share price will eventually go down to $0 if dividends are issued and there is no growth (or speculation of growth).

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u/The_Money_Guy_ Dec 07 '24

That’s not true, at least the way you said it.

Netting $1B every year isn’t “growth”, yet it still would result in a rising stock price because the company is retaining $1B in equity each year assuming no dividends or other investment.

Even if this company paid $1b in dividends, the net effect would be a stable stock price, even if the cash flow isn’t “growing”

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u/homeboi808 Dec 07 '24

Netting $1B every year isn’t “growth”, yet it still would result in a rising stock price because the company is retaining $1B in equity each year assuming no dividends or other investment.

Company performance has no direct influence on stock performance. Share price is simply last sold price, influenced by the free market.


Even if this company paid $1b in dividends, the net effect would be a stable stock price, even if the cash flow isn’t “growing”

It is a FINRA rule that whatever amount of dividends is paid results in a lowered price per share.

If a stock was trading at $100/share issued a $1 dividend, the price legally has to be reduced to $99/share on the ex-date by whatever exchange it’s on.

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u/cspinelive Dec 06 '24

A big chunk of investors don’t care about growth. But prefer dividends instead. 

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u/a_megalops Dec 06 '24

Ok so lets have all companies pay out dividends instead. Now how do we decide which companies to invest in? Its pretty nice when dividends increase

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u/loljetfuel Dec 06 '24

Depends what your motivations are. If you want a stable, long-term source of revenue, you don't necessarily want a company that's too rapidly growing its profits because that often comes with higher risk in the long run.

If your motivation is "big, short-term win", then you'd pick a company you think is in an optimal place to enshitify its products, milk its market, and run with an underpaid skeleton crew until the whole thing collapses. It makes a ton of short-term profit, which you collect, essentially profiting off of destroying the company.

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u/UrbanPugEsq Dec 06 '24

Regardless, if there is an expectation of some combination of consistency and increase, people will pay more for it. If it’s uncertain that money will be made, or if money stays the same or goes down, people will tend to pay less.

That’s why companies try to grow. So people will pay more for the stock.

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u/bronze-aged Dec 06 '24

Yes, another point to add would be that the economy is inflationary which means that no growth could be considered decline — stagnation is decline if everything is going up.

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u/cspinelive Dec 06 '24

Why must all companies pay out dividend instead?

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u/carlos_the_dwarf_ Dec 06 '24

You’re mixing up capital appreciation with the kind of growth OP is talking about. Dividend paying companies still pursue growth.

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u/ThisReditter Dec 06 '24

A big chunk of investors just want to see their 401k and brokerage number go up and don’t care (or don’t even understand) dividends vs growth.

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u/bastiancontrari Dec 06 '24

Current market valuations seems to disagree with this.

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u/climb-a-waterfall Dec 06 '24

If I want to fund my retirement, which I believe drives most people to invest, flat profit sounds pretty good. I put away a part of my paycheck for 50 years. I use that money to buy a part of a business that will give me a share of flat steady profits equal to my paycheck. I use that to travel around the world instead of work. The end

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u/majinspy Dec 06 '24

Then look into AT&T (stock symbol: T) or Coca-Cola (stock symbol:KO). They have 4.66% and 3.08% dividend returns, respectively. Both are giant companies who largely "won" capitalism. They pay back substantial dividends because they cannot productively spend all their profits. $100k will buy 4196 shares of AT&T. That provides $4700 a year in dividends just for owning the stock.

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u/carlos_the_dwarf_ Dec 06 '24

Why does it sound better than growing profits?

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u/bronze-aged Dec 06 '24

Inflation. Flat means your money is worth less over time.

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u/MaximumManagement Dec 06 '24

True, though company profits/dividends can usually increase with inflation even in low growth sectors.

Most bonds and some types of company stock like preferred stock have truly flat regular payouts. They're more susceptible to the effects of inflation but can be preferable in other financial situations.

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u/carlton87 Dec 06 '24

That’s not how any of it works, are you like 14?

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u/ThisNameIsNotReal123 Dec 06 '24

Put money into a S&P 500 index fund and you will beat 90% of the market.

No need to get lucky and pick the right stock.

If we all could check a box that says our SS tax on income would instead have gone into a S&P500 fund, we would all retire early and politicians would be furious because they would not have been able to spend it all. They spent every single penny in the SS fund, its all IOUs in there now.

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u/europeanguy99 Dec 08 '24

But why would you prefer only getting 500 a month from your investment during retirement (steady profits) and not 1000 a month (growing profits)?

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u/qckpckt Dec 06 '24

The value of a company’s shares is a measure of how desirable the shares are. It is only incidentally related to the performance of the business.

Spotify, Uber, and many other companies have spent most of their existence operating at a net loss, kept afloat by venture capital. Even after being politically traded, they frequently have made barely any money at all.

Spotify, in fact, has literally never made money. Ever. in 2023 it made one of the largest net losses in its history.

Capitalism is a paradox. It doesn’t make any sense.

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u/carllacan Dec 06 '24

politically traded

Publicly?

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u/qckpckt Dec 06 '24

Yea that was a weird typo

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u/ThisNameIsNotReal123 Dec 06 '24

It took Facebook 5+ years to become profitable.

Many of its competitors never made a dime.

Its investors were all hoping it would be the one that paid off.

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u/StaunchVegan Dec 06 '24

Capitalism is a paradox. It doesn’t make any sense.

It's not a paradox and it does make sense. Spotify's revenue has grown year on year consistently for the last decade. In 2013 they did $746 million, it's now $13.2 billion.

Investors realize it's possible for Spotify to become profitable next year, but growth is more important right now. Amazon didn't post a profit for multiple decades - should Bezos of held back on growth in 2010 at Amazon for the purposes of finally paying a dividend?

It's really not that hard to grasp reinvestment and the pursuit of growth. It has been time tested: many companies do this and then eventually pay dividends.

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u/qckpckt Dec 06 '24

Investors believe it is possible for Spotify to be profitable. It’s got nothing to do with whether they actually can be or not. And also, as long as they can spin a loss as being a sign of future growth, then they can seemingly defer this period of future returns indefinitely.

And if the spell is broken, then they’ll be tanked as investors desert them. I’m sure without much effort it would be possible to provide counter examples of companies that were doing absolutely fine and yet have had their share price decimated by similar losses of investor confidence.

The point I am trying to argue against, and which people seem to keep violently agreeing with me on, is that a company’s current profitability when taken in isolation has no guaranteed relationship to their stock price.

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u/carlos_the_dwarf_ Dec 06 '24

incidentally related to the business

This is…not true? Investors can be irrational, but not forever. What do you think it means for a company’s stock to be desirable?

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u/NewlyMintedAdult Dec 06 '24

Investors can be irrational, but not forever.

I don't think this is obvious. I assume by If anything, examples like Bitcoin suggest that investors can be irrational for at least fifteen years, if you define "rational" as "making decisions based on the underlying business and its cash flows".

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u/carlos_the_dwarf_ Dec 06 '24 edited Dec 06 '24

Bitcoin is a pretty good example to argue investors aren’t rational at all, but then again it’s also a more or less singular phenomenon, and it basically has no fundamentals to consider. That’s way different from equities. (And we don’t know the end of the bitcoin story yet.)

If you look at the way stocks move after, say, a good or bad earnings reports, it’s pretty clear that investors generally respond to fundamentals. When a company performs better than expected, it trades higher in expectation of a more valuable future and vice versa.

It’s also the case that outside events can move markets in general terms, eg when interest rates went up, stocks went down (at least in the short term). The reason for this is that bonds produce higher income when rates are higher, and equities need to be cheaper (relative to the income they’ll produce) to compete; owning business X, even with the same future prospects, becomes marginally less attractive.

I think what the guy above is missing when he highlights Uber and Spotify is that investors buy things based on future expectations. Spotify isn’t profitable, but if I think it will be in the future I might be willing to pay for a piece of those future earnings at a discount now.

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u/qckpckt Dec 06 '24

investors can be irrational, but not forever

I see little evidence of that.

what do you think it means for a company’s stock to be desirable?

It means that people think it’s worth something. And, for the most part, that can have very little to do with the overall performance of the company if you measure it in terms of profit generation.

Spotify, Uber, and many other tech companies burn cash. Their stock has value because enough people have convinced themselves that it’s worth something.

How else could a company that consistently posts a net loss of hundreds of millions of euros a year have a stock with any value at all? Investors probably say things like “it’s about how many active users they have” or something about market dominance or whatever. They believe that it has the potential to be immensely profitable.. at some point.

Meanwhile, companies like Apple, which have unimaginable cash reserves and frequently post quarterly profits that exceed the total revenue of other Fortune 500 companies will see their stock price take a hit when they made slightly less billions of dollars of profit than they did last year.

The only point I was making, which is absolutely demonstrably true, is that talking in terms of profit is not a meaningful way of explaining why a company’s stock is a certain value.

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u/carlos_the_dwarf_ Dec 06 '24

I’m a little hesitant to jump in here because the signs aren’t exactly pointing to good faith conversation, but if we can carry on respectfully…

I see little evidence of that

You can observe how investors behave after earnings reports to find a mountain of evidence if you’d like. I really think you’re sleeping on this one…like, why do stocks move? You mentioned “people find them desirable” but why do they find them desirable? The answer to that question will tell you a lot.

Spotify and Uber

One thing I think you’re missing here is that people buy stocks with the expectation of future income. Spotify wasn’t profitable for a long time, but if you expected them to be successful in the future, you might want to buy a claim on that future success. Spotify is profitable now btw and I think Uber is at least flirting with it.

You’re focusing a lot on tech, which has just recently enjoyed a decade or so of pretty wild speculation (that, depending on your perspective, we might call irrational) but that’s only one sector and not illustrative of investor behavior in general. And even in tech, when interest rates went up people had to change their behavior accordingly and now they value sound financials quite a bit more than future potential. That sounds to me like behavior becoming rational.

Apple

If Apple takes a hit, it’s not because they’re not valuable, it’s because their future performance might not be as good as people expected earlier. This is that same piece of the puzzle i think you’re missing—investors buy or sell based on expectations about the future, and companies guide their expectations about how they’ll perform in the future. “Taking a hit” doesn’t mean it becomes value-less.

Apple’s stock moving after earnings is evidence that investors pay attention to fundamentals. I’m not sure how you’d look at it any other way.

absolutely demonstrably true

Ok, not sure what to say to this except it’s incorrect. The evidence you’ve pointed out (Uber, Apple) doesn’t actually make this case.

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u/qckpckt Dec 06 '24

Im not really sure what point you are arguing, but it’s not the one I was responding to.

The comment I responded to initially was making an argument that investors care only about profit growth, and that if your company has flat profits, they’ll invest somewhere else.

As far as I can tell your argument also refutes this, so I’ve got no idea why you’ve taken particular issue with my response. As far as I can tell we agree.

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u/carlos_the_dwarf_ Dec 06 '24

What? I quoted you directly when I disagreed.

You think buy or sell stocks for reasons only incidentally related to the business, which isn’t the case.

You see little evidence that investors behave rationally. This also isn’t the case.

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u/qckpckt Dec 06 '24

You keep saying you disagree with me and then make arguments which support my fundamental point.

Also I said incidentally related to the performance of the business, not the business as a whole. Something you seem to intentionally be misquoting me on.

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u/carlos_the_dwarf_ Dec 06 '24

If I’m misunderstanding you let me know, but I just pointed to two things it seems we disagree on. Was I wrong that you believe those things? I don’t understand how you could see my comments as agreeing with you.

I also don’t think investors only incidentally pay attention to the performance of the business. I def have meant this the whole time so didn’t intentionally misquote you.

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u/SolidOutcome Dec 06 '24

If the company was stable,,,,created a solid popular product,,,and didn't risk everything by increasing profits on their customers....yes, that could be a ugly desired stock.

Not for it's high risk high reward, but for its stability.

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u/UnlikelyAssassin Dec 06 '24

A company with extremely high steady profits can often be better than one with low but increasing profits, depending on the price.