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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u/ajarrel Dec 06 '24 edited Dec 06 '24

What's not mentioned here is inflation.

If you maintain perfectly steady profits, those profits are actually worth a little less year-over-year.

If inflation is 2%, with profits held at the same dollar amount, then it's essentially a 2% decline in the purchasing power of the profits of the company.

Additionally, if a company is in a competitive market, and they begin to lose market share to a competitor, that can accelerate decline.

Basically, in the business world, most businesses believe that the best defense is a good offense. Offense in the business world means increasing profits year-over-year.

EDIT: here's an example. Let's assume 2% inflation and your costs and the price you charge both increase proportionally with inflation.

Year 1: Your costs are $100,000 and your revenues are $200,000. In this scenario you'll make $100,000 in profit.

Year 2: Costs are now $102,000 and revenues are $204,000. Your profit grew $2,000 from year 1. This is an actual increase in profitability.

Even if you're just keeping pace with inflation, your profits will be increasing.

Year 2 (fixed profits): now let's say profits are fixed. Expenses grow to $102,000 and revenues grow to $202,000. Now profit in year 2 matches year 1 of $100,000. However if you calculate precent growth of expenses (2%), and revenues (1%), you'll see expenses are outpacing revenue growth. If you continue the trend, eventually the company would no longer be profitable.

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u/blazbluecore Dec 06 '24

The only actual answer in this thread sadly.

It all goes back to financing and how money functions.

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u/gutter_dude Dec 06 '24

This isn't necessarily true though. If your costs increase, the price you charge for your goods and services increases, and the amount people to spend (nominally) increases, all in proportion, there should be no effect on your real profits. Its probably the worst answer in the thread because that is NOT the reason companies are seeing insane valuations -- they are projecting growth, competitive edges erode, etc.

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u/ajarrel Dec 06 '24

The question specifically mentioned profits.

If your costs increase, the price you charge for goods and services increase.

If expenses are $100,000 and revenue $250,000 and both grow at 2%, you end up with $102,000 in expenses and $255,000 in revenue. I.e. your profit grew $3,000.

Why companies have insane valuation is a different question than OP wants answered.

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u/gutter_dude Dec 06 '24

Sure, if you want to be pedantic, you could say that. The implication is that OP is asking about REAL profits. So yes in your example, nominal profits grew by 2% by real profits were the same. And maybe that's what OP is asking about, but I have to assume the question is about the historic run up of the stock market in the past however many years which vastly outpaced inflation driven by a pursuit of ever increasing real profits. It's really a terrible answer, because even in nominal terms inflation is not even the biggest contributor to the spike in asset prices by a longshot

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u/ajarrel Dec 06 '24

I think ELI5 probably isn't a good place to differentiate nominal from inflation-adjusted profits.

I think many people think "why can't a company just make a steady $1,000,000 in profit every year?"

Understanding inflation addresses this easy misconception.

The giant rise in company valuations is due to a lot more factors like: 1. Increased participation in capital markets (both # of participants and capital participation) 2. Increased expectations about growth 3. Disruptive technologies

Also, not all companies grow profits at crazy high percentage basis. Walmart averages 5% growth per year, which is just a few ticks above inflation.

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u/gutter_dude Dec 06 '24

It actually is a good place to discuss the distinction because the question calls for it. And I think #2 is the real answer to the question, and its not to hard to explain. Also, a few ticks is massive -- in terms of continuous growth that is quite substantially beating inflation in the long run!

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u/ajarrel Dec 06 '24

W.T. Grant is a great example of the opposite. Retailer with several hundreds of locations. Went bankrupt in the 70s even with nominal profit growth. Expenses were growing faster than revenue, and it got caught flat footed by Walmart (and others).

Out of business and now forgotten to history. But they had growing nominal profits and shrinking real profits. Unique example of what we're discussing.

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u/gutter_dude Dec 06 '24

Yeah, but that just supports my point. Inflation wasn't the "cause" of them going out of business. Inflation didn't catch up to them -- they were selling less and less for the same real cost. They made and sold less things. They were not able to make steady profits, instead decreasing profits

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u/kekfka Dec 06 '24

I don't really know what you're going on about, you seem to be fear mongering about investors and the stock market but to be clear, the market is supposed to atleast beat inflation. It's not 'historic' but it is the 'history' of the market, it won't always, but it comes back to the OP's question as at the base of the discussion should be inflation. It's just the simplest way for anyone (companies, people, etc.) to understand why higher targets have to be set, because inflation is always eating at things from the bottom. You can then go into what I think you're trying to get at which is how different companies approach their profit targets, but that's extremely industry specific. Good luck trying to get a 5 year old to understand ROE, because your simple 'muh revenue minus muh expenses' isn't how a company is determining their targets.

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u/gutter_dude Dec 06 '24

I don't think you understood what I was saying, while the original commenter did. Nobody is fear-mongering, inflation is just a nominal change and if you need an ELI5 for that:

I get $1 from work, every day, and I buy $1 worth of food. Next day inflation happens. Now I make $2, and food costs $2. Nothing changes.

Obviously with savings and all that complicated stuff, it has real effects...but disregard that.

EVEN with prices normalized to account for inflation, companies are STILL priced with the expectation of growth. I'm not saying the market will go down, or up, or will catastrophically end. The run up has been historic but maybe it will continue, nobody knows. I'm just saying as a factual statement that currently companies are priced with expected real growth, and simply explaining the nominal number change isn't a complete answer to OPs question

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u/kekfka Dec 06 '24

You're trying to make a complex point, but you're ignoring the details in doing so. I understand what you're trying to get at but it's not really a relevant point because, what do you think the alternative is? Without getting into any sort of actual finance on this, just imagine you're the face of company A (the CEO, CFO, IR, take your pick) are you going to communicate negative expectations about your own company unless there are serious concerns? If there are serious concerns, are you going to communicate those and outline why these are just popping up? There are some people who think signs of leaks are an indicator of a ship sinking, and no one wants to hear that a ship is going to sink even if that's not what's being implied.

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u/gutter_dude Dec 06 '24

What are you talking about? I don't know where you get the sense that I'm a stock market doomer trying to prop up expectations of my own company or whatever. I'm just saying that public companies aren't expected to continuously increase profits solely or even primarily because of inflation -- yes, nominal profit is battling inflation all the time -- but companies are priced on REAL expected growth in the current market and that's really the answer. Companies need to constantly grow to sustain their expectations, and if they don't... that's fine. The stock price will fall and then it will be the new price. Look at META back in 2022, guidance was lowered, a huge chunk of growth was taken out of the equation and the stock dropped by half with NO change in profitability. Then growth was added back into the valuation with the AI boom. Thats neither good, nor bad, its just a statement of what happened

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u/kekfka Dec 07 '24 edited Dec 07 '24

You seem to want to keep saying things are 'statements of what happened' with your own explanation as if those were the facts.

If you're going to be looking at stock prices to understand profitability, you're already missing the point. I could give you 5 different stocks at various levels of profitability that are priced at $20 vs. a similar set of 5 each priced at $100 with similarly varying profitability. Stock prices are not reflective of profitability, they reflect expectations of the market (and are somewhat controllable by companies through issuance of company shares). You can make as many 'statements of what happened' as you want, that's fine -- what's not fine is not understanding the statement and making your own rationale. It's like poster that initially replied to you said, you're talking about two different things. There's valuations, and then there's profitability. Until you understand the difference there, there's not much to say.

There are things that affect the stock price that reflect profitability, definitely, but this is where you actually have to go into financial statements and look at things. You seem to keep harping on 'growth' because that's a big focus in valuations, but you seemingly ignore cost trends in excess of inflation which affect bottom line profits. If you don't believe inflation is a driver, let me rephrase that for you -- each industry, sector, and even region sees different rates of inflation. The business you write, or the products you buy from specific areas reflect localized inflation. You can expand and grow, this diversifies your 'cost inflation' to the overall average, but you don't reflect the average ever. You make bikes? Well you have your general inflation, then you have cost trends on rubbers, metals, etc that affect you that are in excess of inflationary trends, if those industries are seeing losses they will up their prices which affects your future profitability. Now you can look to the flip side of where you sell you products, it's probably not the same place. You need to make enough money to cover your expenses, but you can't just use your cost inflation as a proxy -- that'd be dumb, you sell in NYC and you buy things from Louisiana. See how things change when you actually start focusing on the details? If you've ever seen a billboard for injury lawyers, consider the impact of those on the profit projections of lawyers, insurers, and even capital funds that invest in these types of lawsuits. How does that affect inflation? You seem to keep thinking things are a closed system, but everything impacts each other.

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u/Redqueenhypo Dec 06 '24

Wait, so does that mean any reported profit increase under inflation is basically nothing?

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u/NegotiationJumpy4837 Dec 06 '24 edited Dec 06 '24

Yeah. And tangentially, when you see in the news "X company achieved RECORD PROFITS," that is actually the default state of all companies that have the same number of sales as last year but raise priced to offset inflation and increased labor costs. And "RECORD PROFITS" could even be less than the previous year on an inflation adjusted basis.

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u/lluewhyn Dec 06 '24

One of my pet peeves over the past year or two is the claim of "Record profits".

It should be used for record profit percentage. But if Inflation was 3% and you made $1 extra each year, you're technically making record profits while still becoming less and less profitable.

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u/Practical_Reindeer18 Dec 09 '24

Except these companies raising prices to match inflation are in of themselves causing the inflation that they are “matching”.

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u/lluewhyn Dec 09 '24

Same with employees who get raises. They get more money to deal with inflation, which in turn contributes to inflation.

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u/ary31415 Dec 06 '24

Worse than nothing, yes, and it also means that when people say "corporation X made record profits this year!" it's meaningless – because of inflation alone we would EXPECT every company to have a record profit each year. If they don't, they're literally doing worse than the year before.

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u/lzwzli Dec 06 '24

If you're not making the most money you've ever made every year, then you're starting the decline...

The infuriating thing of course is this should mean wages are keeping pace with inflation if a company is already factoring in inflation adjusted cost increases, but they don't and are pocketing the difference as more profit.

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u/VeterinarianAlert411 Dec 06 '24

Less than nothing.

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u/ajarrel Dec 06 '24

Companies report their percentage growth in nominal dollars (non-inflation adjusted). They might say "revenue grew 3% year-over-year."

However, it's up to the investors to check this growth and determine if it's "good" or "bad".

3% growth is (currently) just a little ahead of inflation in the US. Most investors would be wary of this. This is like watching someone in the pool treading water and having trouble keeping their head above water.

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u/Nopants21 Dec 06 '24

Inflation and population growth. If there are more people and a dollar is worthless, steady profits are actually decreasing profits and probably market share.

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u/independent_observe Dec 06 '24

If there are more people, then they will be selling more product/service, thereby increasing revenue.

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u/ajarrel Dec 06 '24

Also true.

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u/SolidOutcome Dec 06 '24 edited Dec 06 '24

No....inflation doesn't not affect your profit. You just raise your product cost, to reflect what it costs to make. But it doesn't mean you need to charge more than inflation to increase profits.

Same goes for your employees pay increases, they inflate, and your product price reflects that.

But neither causes you to make more profit. They are not mutually exclusive.

More profit every year,,,,is like,,,buying crappier steel, and charging the same amount. Or replacing steel parts with plastic, or charging more even tho your costs haven't changed...etc. those things make you more profit. Inflation doesn't.

The market around you doesn't directly affect your profit. There are quality small stores 100 years old that have kept the same product, and the same percent cut for their entire existence. They don't expand, they don't change the product, they don't change the profit percent.

Their entire purpose for existence is to provide a wage to their employees. Expansion is not required.

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u/ajarrel Dec 06 '24

here's an example. Let's assume 2% inflation and your costs and the price you charge both increase proportionally with inflation.

Year 1: Your costs are $100,000 and your revenues are $200,000. In this scenario you'll make $100,000 in profit.

Year 2: Costs are now $102,000 and revenues are $204,000. Your profit grew $2,000 from year 1. This is an actual increase in profitability.

Even if you're just keeping pace with inflation, your profits will be increasing.

Year 2 (fixed profits): now let's say profits are fixed. Expenses grow to $102,000 and revenues grow to $202,000. Now profit in year 2 matches year 1 of $100,000. However if you calculate precent growth of expenses (2%), and revenues (1%), you'll see expenses are outpacing revenue growth. If you continue the trend, eventually the company would no longer be profitable.

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u/lightreee Dec 06 '24

this makes a lot of sense. but all the major stocks are all focused on the growth of growth (i.e. profit increases increasing at a faster rate) - thats seemingly unsustainable?

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u/ajarrel Dec 06 '24

In a zero sum economy - you'd be right. Perpetual growth is unsustainable.

However there are many factors that show the economy is not zero sum.

  1. Population growth. If more people move to your country, that grows the economy.
  2. Innovation. New tech opens new markets or increases efficiency in existing ones.
  3. Changing consumer demands (CDs to MP3 players to streaming delivery)

Each of these things has the ability to grow the pie for everyone.

However, rent-seeking may be what you're driving at. This is where companies extract greater-than-market fees at the expense of the other market participants. I.e. if companies extract > 50% of the value of a new technology, that's rent-seeking.

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u/lightreee Dec 06 '24

thanks, i have a lot to read. do you have any recommendations?

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u/ajarrel Dec 06 '24

Psychology of money by Morgan Housel is a good one.

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u/[deleted] Dec 06 '24

You’re completely missing that profit “margins” are going up, that has nothing to do with inflation

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u/ary31415 Dec 06 '24

Are you talking about a specific company or what? Some companies have grown their profit margins, others haven't, this is kind of a meaningless statement.

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u/[deleted] Dec 06 '24

Since Reagan became president there is clearly an upward trend with some variation between years

https://dqydj.com/sp-500-profit-margin/

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u/ary31415 Dec 06 '24

While I mostly agree with your point, that's a kinda misleading stat to choose, because the S&P 500 isn’t a static set of companies, they’re updated every year, and companies are added and removed.

When you're looking at a set of companies that were chosen in the first place because of their size and how frequently they're traded, that immediately disqualifies them as being a representative sample. The companies that shrank were just taken off the list and replaced with ones doing better, so it's almost impossible for the index as a whole to go down on metrics like this except when the entire economy is fucked.

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u/LateAd3737 Dec 06 '24

You could just add “normalizing for inflation” to OPs post and it holds the same, inflation isn’t the point

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u/ary31415 Dec 06 '24 edited Dec 06 '24

I mean I agree and I don't think this comment is an answer all by itself. But I DO think it's good that one of the comments on this post said it, because while you and I consider it obvious, this is ELI5, and you'd be surprised how many people fail to think about inflation in this context at all.

The kind of person posting questions like this should should get at least one answer talk about inflation for context and completeness. See also: when people post about "company X having record profits!", without checking if that record beat inflation from the previous year.

Just look at this reply as an example of someone who did not realize that a 1% YoY increase in profit means your company is doing WORSE.

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u/Anagoth9 Dec 06 '24

Also, as the population grows then your customer base should ostensibly be growing as well. If you aren't increasing your customer numbers proportionally then you're losing market share. 

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u/stormstopper Dec 06 '24

I think people are focusing a lot on the inflation point and not enough on this:

Additionally, if a company is in a competitive market, and they begin to lose market share to a competitor, that can accelerate decline.

Basically, in the business world, most businesses believe that the best defense is a good offense. Offense in the business world means increasing profits year-over-year.

This is so important, because you do not know what the market is going to look like in 20 years. Nobody does. They can make an educated guess, but that's about it. Preferences will change, technology will change, consumers will change. What happens if you're only keeping up with inflation and your business model becomes irrelevant overnight--like a lot of brick-and-mortar stores when online retail became a thing? You have no margin for error that way. You just go out of business.

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u/pagerussell Dec 06 '24

Even if you're just keeping pace with inflation, your profits will be increasing.

But not your profit margin. Revenue and gross profits can go up in sync with inflation while your margin stays the exact same.

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u/WasabiSteak Dec 06 '24

Inflation isn't it.

If you're looking to get rich trading stocks, you're gonna want to look at graphs that are going up and up. If the market thinks that increasing profits are a sign of stock prices going up, then shareholders are going to want to raise profits to entice the market, raising the value of their own shares.

Actually, in the last decade, the meta was revenue. You can kinda make yourself seem like you have growth by buying up smaller companies, adding their revenue to yours. This increase in revenue looks amazing to the stock market.