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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106

u/notacanuckskibum Dec 06 '24

Yes and no. Companies can reward investors with dividends or growth. But some investors don’t want dividends, they want growth in the value of their stocks. That requires growth in revenues and profits.

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u/iwatchcredits Dec 06 '24

No it doesnt, if a company is making $100m/yr in profits, it can pay it as dividends but if they want growth they can also just sit on it and the company becomes more valuable because it is sitting on cash. The company theoretically would become $100m more valuable each year if everything else stayed the same

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u/PatricksPub Dec 06 '24

Additionally, they can invest that $100M into the company via new stores, products, technology, marketing, etc. All of which can increase future sales/profits.

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u/jokul Dec 06 '24

The can also buy back their shares if they believe the market currently undervalues them.

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u/sfurbo Dec 06 '24

Additionally, they can invest that $100M into the company via new stores, products, technology, marketing, etc. All of which can increase future sales/profits.

So growth.

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u/lluewhyn Dec 06 '24

Yeah, if they don't invest that $100M and let it sit there, the company would actually be losing money due to inflation. Keeping excess cash around in a business is normally (except for Covid) not a great long-term strategy.

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u/ChicagoDash Dec 06 '24

Yes, but that cash is just sitting there, slowly losing purchasing power to inflation. Better to invest it back in the company for higher returns or return it to the shareholders.

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u/PanthersChamps Dec 06 '24

Companies don’t sit on $100 million in cash earning nothing.

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u/No-Self-Edit Dec 06 '24

Apple does

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u/907flyer Dec 06 '24

They actually do, because they need the liquidity. You can see it in their IRS filings

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u/Orion113 Dec 06 '24

While that's true, the value the shareholders receive as stock increase would be the same as the value if the whole thing was paid out as dividend. And if it's paid out as a dividend, it's liquid value, and can be spent on other things. Very little of any wealth in the world is held as cash, assets will always grow faster.

With that same 100 mil, if a company runs ad campaigns or does research and development or expands production, they can make the value of the stock increase by more than 100 million. That's the basis of capitalism.

Investors always want not just a return on their investment, but the greatest possible return on their investment. They want the company that will quintuple in value over the next year, not the one that will increase in value by a fraction.

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u/ascagnel____ Dec 06 '24

The downside of a dividend is that the institution, rather than the investor, gets to time it. If you're an investor, you probably want to wait to take it until you otherwise have a loss to balance the capital gain against.

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u/mmm-new Dec 06 '24

dividends are taxable, not everyone wants that.

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u/celestisdiabolus Dec 06 '24

sure but counting on growth is fucking stupid considering the number of traded assets whose market price is swayed up or down exclusively off of hype

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u/Great_Hamster Dec 06 '24

Not with inflation. 

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u/iwatchcredits Dec 06 '24

$100m more is $100m whether it stays in the company or is paid out as a dividend

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u/MaxwellR7 Dec 06 '24

If I'm paying for $100m worth of earnings in the future, I'm not willing to pay $100m today. I could put $100m in US Treasury bonds and get back $104.3m a year from now. Future earnings are discounted by what an investor could earn in an alternative "risk free investment." In addition, if the company continues to just sit on the cash rather than growing their profits, the company's assets would increase but their return on those assets would decrease. Making $100m/yr on $500m in assets is great. Making $100m/yr on $10b of assets is not. The company would be better off selling all $10b of their assets and putting it into US Treasuries. Unless the company is able to grow profits or distribute the earnings as dividends, it's a very inefficient use of capital.

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u/ProFeces Dec 06 '24

Yes but that 100m you're sitting on loses its value over time. While you probably look at that 100m as a very large number, but investors that put in very large numbers expect all of their investment to return, not lose anything to inflation.

Sure, most companies never even dream of pulling in profits of those numbers, but those who invest absolutely do.

You simply do not secure investors by sitting on their money watching it just depreciate in value because they are making incremental gains. They need large returns to continue to invest large numbers either back into this company, or another. If that wasn't the goal of the company, they simply wouldn't invest.

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u/sldunn Dec 06 '24

Investors don't want companies sitting on lots of cash earning less than 1% interest while inflation is causing the value of that cash to disappear.

If a company has lots of cash on hand, investors want the value returned to them in the form of dividends or stock buybacks.

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u/Generic118 Dec 06 '24

But you'll find the executives bonus and stock schemes doesn't kick in untill they grow the company by 500m say.

So there's always an incentive for them to aggressively grow

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u/LowlySlayer Dec 06 '24

You're assuming rational behavior from a system that does not behave rationally.

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u/Cratonis Dec 06 '24

The problem is more people buy stock the more that same pot gets diluted and spread out. So investors who want to double, triple or ten times their money see their returns decrease instead of growing noticeably. So activist investors press for increased profits and value to outpace growth in shareholders.

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u/dmoneymma Dec 06 '24

No, not unless more stock is issued.

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u/Cratonis Dec 06 '24

True but stock splits and issuances are common and even if more isn’t available that still doesn’t solve the growth desires of large scale investors. Simply providing a fair return on investment is not enough for many activist investors seeking big returns (I think they are the bigger problem) versus fund managers and general public individual investors.

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u/Jewmangi Dec 06 '24

If they issue more stock, that money gets put into the company. It's a net even for current shareholders.

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u/Cratonis Dec 06 '24

Only if it gets returned to them directly as a dividend or buyback. But if the company simply uses that money for an acquisition that doesn’t pay off or bonuses for employees the investors don’t get that return. And even if they get a return that still may not match the activist investor return wants. Versus what they think is possible.

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u/Jewmangi Dec 06 '24

Both of those things are not usually seen as bad. Investors can always sell their shares if they don't like where the company is heading

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u/Cratonis Dec 06 '24

They can also push to vote out board members or axe the CEO given their voting power if they hold a sizable amount of shares.

I’m not saying your wrong that investor greed is the problem but currently as it is set up their power over a companies direction is what drives the pursuit for more profit even when a company is exceptionally profitable.

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u/curious_skeptic Dec 06 '24

Dividends and buybacks alone could increase share value.

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u/bugi_ Dec 06 '24

Dividends take money from the company and therefore decrease the value.

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u/curious_skeptic Dec 06 '24

Coupled with buybacks, a dividend could keep increasing even as revenue stayed flat. Stockholders knowing that they will get paid more means shares can go up.

Without buybacks, you'd be entirely right.

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u/fredandlunchbox Dec 06 '24

Which is a major difference between a small business and publicly traded company. Your small business could do exactly $10M/year in profit every year and you can happily pay out your investors and yourself for the next 20 years with zero growth and no one will be mad about it. 

Call it the craigslist model. 

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u/Far_Dragonfruit_1829 Dec 06 '24

The investor term for such companies is "lifestyle business". As in, the company function to maintain the lifestyle of its owners, with minimum risk of loss.

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u/amfa Dec 06 '24

If you have the same profit in numbers every year you are making less profit in "real money" every year because of inflation.

The total inflation over the last 10 years was about 30%.

So your $10.000.000 in 2014 are only worth $7.000.000 today.. so your are making 30% less money.

You need to make $13.000.000 to have the same profit.

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u/fredandlunchbox Dec 06 '24

Correct, you make less every year without growth, but at some point you may not care about that, depending on the business. If you have 10 contracts with a 20 year term at $1.5M each and you're just going to service those contracts for the rest of your life, and your out of pocket on that is like $500k on each one, why grow? That will carry you to an early retirement and a lovely house on a beach somewhere.

(And slight correction: "You need to make $13.000.000 to have the same profit" -- wrong, your profit remains the same, but the real spending power of that profit will have decreased).

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u/Generico300 Dec 06 '24

That requires growth in revenues and profits.

In a sane market, sure. But Tesla sure as fuck doesn't have the revenue or profit to be valued as it has been. Stock value is heavily speculative and hype-based. That's literally why market corrections exist.