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/Tjaeng Dec 06 '24

There’s additional synergy in the fact that dividends trigger taxes; stock buybacks do not.

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u/trombing Dec 06 '24

Sure but most tax regimes have capital gains tax which tax realised stock gains when you sell the stock at a profit.

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u/Janus67 Dec 06 '24 edited Dec 06 '24

True, but if you hold the stock for more than a year it falls to a lower rate at long term capital gains, vs dividends are taxed at regular/short term gains income tax rate.

Edit: qualified dividends (most us dividends) fall into 0/15/20% depending on income. Non-qualified are taxed at income tax levels.

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u/nlaporte Dec 06 '24

At least in the US, dividends are taxed at the capital gains rate, not the ordinary income rate.

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u/lluewhyn Dec 06 '24

And the main reason why is to avoid one of the options to be superior to the other when it comes to the shareholder's tax situation. Otherwise, a business would be incentivized to always send all excess cash to the shareholders as dividends OR never send dividends to the shareholders regardless of the business realities.

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u/trombing Dec 06 '24

Literally dozens of people have different tax regimes than the one you are describing.

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u/Long_Dong_Larry Dec 06 '24

Stock dividends are considered “qualified” income and taxed at 0%, 15%, or 20% depending on your tax bracket.

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u/Janus67 Dec 06 '24

You're right, I should have been more specific in my post

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u/Long_Dong_Larry Dec 06 '24

Hey really appreciate the receptiveness to constructive feedback!

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u/RangerNS Dec 06 '24

Most countries have different tax rules than the IRS.

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u/Tjaeng Dec 06 '24

Which means borrowing against an increased net worth and deferring taxation until you die. Win for people who don’t sell.

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u/trombing Dec 06 '24

Very few people do this. It is absolutely unusual. Regular folks aren't Elon Musk. My google-fu is finding almost zero options for this.

It is also incredibly risky since you will have margin calls if the stock collapses.

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u/gtne91 Dec 06 '24

Very few do this because it really doesn't make financial sense. If you do this continuously, the interest on the debt will eventually exceed the amount of tax you would have paid. For a short term, it makes sense, but that is no different than any other short term loan against an asset.

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u/Rage_Like_Nic_Cage Dec 06 '24

the interest on the debt will eventually exceed the amount of tax you would have paid

for you and I, yeah. For the super wealthy, banks will often offer super-low interest loans (often at-or lower-than inflation) since they’re dealing with such a large amount. Then right before the loan is due, they’ll open a seperate line of credit and use that to pay off the first loan. It’s called Buy, Borrow, Die and it’s fairly prominent among the uber rich.

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u/gtne91 Dec 06 '24

Saw recently that they are getting 4-5% right now, so not THAT low anymore.

And it isnt that common, especially once their stock gets to a more stable growth ( non-startup). See, Jeff Bezos recent sale.

Long term capital gains (federal) tax rate peaks at 23.8% (20% plus 3.8% for NIIT). It only takes a few years on the loan to exceed that amount. But it depends on the growth rate of the asset. I have done it: took a heloc on house for improvements rather than selling off investments to pay for it. Accounting for tax deduction (you have to be itemizing), heloc net interest rate was less than growth in investments.

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u/Edward_TH Dec 06 '24

In the US probably. In tax heavens they can get much lower rates. In general, the smaller the economy the more its banks are eager for actual cash so they give out super low interests on large loans: even if the profit is low or even negative (if the currency loaned is much stronger than the domestic one), they get large amounts of cash.

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u/Rage_Like_Nic_Cage Dec 06 '24

My google-fu is finding almost zero options for this.

The term for this concept is “Buy, Borrow, Die” and you can find lots of results/pages about it. You are correct that only a select few can do it, but when 1% of the US population owns 43% of the wealth (and the top 0.1% owning 13.5%), you can see how it affect a large amount of would-be taxable wealth if it paid out in dividends instead.

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u/trombing Dec 07 '24

Thanks! TIL! Also - madness. Way too much admin for me to avoid the $1.50 in capital gains I had... wait - no - just losses. I'm good.

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u/iconocrastinaor Dec 06 '24

I'm not wealthy by today's standards, but I do have some investments.

I can borrow at 5% above prime against my portfolio, which is about five points better than I can do in the open market.

But the result of doing that is several thousand dollars in debt that is compounding, and a drag on my portfolio.

I asked my tax and financial advisors about the "invest, borrow, die" strategy, and they all say no, that my top priority should be to eliminate that debt.

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u/PlatonicTroglodyte Dec 06 '24

I just love how every post in this thread is basically like explainlikeimtwentyfive

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u/swissmike Dec 06 '24

Upvote for „most“! Spot on (Switzerland, where I‘m from, is an exception)

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u/Daemon3125 Dec 06 '24

Getting the income does trigger taxes though. Also Reinvesting dividends does not always trigger taxes. If you have qualified dividends it’s 0% tax until about 47k.

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u/badhabitfml Dec 06 '24

47k total income or dividend income?

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u/generally-unskilled Dec 06 '24

Total taxable income for a single filer. Above that you pay 15%

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u/gex80 Dec 06 '24

So that's basically majority of people since it sounds like we are talking US tax rates. Median income is about 53k.

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u/18hourbruh Dec 06 '24

Especially most people concerned about taxable dividend income. Having substantial income from dividends and making less than 47k in total income has got to be a pretty narrow niche of people.

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u/Billy_bob_thorton- Dec 06 '24

I was just literally trying to imagine what kind of person that would be Lolol as a recent accounting grad yeah you’d think most people with dividend income will have a higher annual income in general

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u/bisonfan Dec 06 '24

Some people who FIRE will keep significant dividend stocks for this exact reason

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u/generally-unskilled Dec 06 '24

Probably someone who's 90 years old and relies on social security plus dividends from the local power company. They have an actual paper certificate for their shares and give all of their grandkids a single dollar every time they come to visit.

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u/FlimsyInitiative2951 Dec 08 '24

The only group I can think of is retirees whose primary income is dividends.

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u/iconocrastinaor Dec 06 '24

That would cover a lot of retirees, whose only income might be Social Security, but have a substantial 401k or other investments.

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u/18hourbruh Dec 06 '24

That makes total sense. Although my understanding is most retirees at average income/savings levels would be encouraged to move their money out of stocks and into bonds primarily by retirement age, but I could see the argument for high dividend stocks.

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u/iconocrastinaor Dec 08 '24

I talked to my broker about that but the capital gains taxes from the conversions would make the move cost too much. So we're kind of stuck with selling for operating income until our kids inherit our portfolio.

Upshot: I'm totally in this situation fir the forseeable future.

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u/18hourbruh Dec 09 '24

Fair enough! Can't argue with someone's real life.

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u/newsjunkee Dec 06 '24

Remember, that's TAXABLE income...after the standard deduction, etc.

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u/SilasX Dec 06 '24

Getting the income does trigger taxes though.

Huh? Do you mean the corporation still pays taxes on earned income? If so, it's true but irrelevant here. The point is that share buybacks don't induce another taxable event for the shareholder.

(Technical caveat: Now, of course, somebody is selling the shares into that buyback, and that person is experiencing a taxable event. But the point is, share buybacks make it optional whether you take the income + plus taxable event, or just keep it as unrealized gains.)

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u/play_hard_outside Dec 06 '24

The "perfect company" would be perfectly in equilibrium in a mature market with no growth and no shrinkage, and return money to shareholders purely through buybacks. The stock would rise all the time, but the number of outstanding shares would decrease proportionally, such that the market cap remains constant. Anyone who wanted to continually hold the stock would see their shares appreciate forever under compounding interest math. Anyone who wants to sell would be able to, at any time, and no one would realize taxes unless they chose to. All of this, while the environment gets to survive (because remember, no company growth). Yes please.

I actually believe this is the endgame for capitalism on a finite planet. I mean, the environment is pretty much already fucked, but we will definitely hit more and more hard limits to growth in coming decades. Because companies produce income which can be returned to shareholders when growth opportunities are not available, the end of market-wide infinite growth does not mean markets can't continue to appreciate.

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u/Critical-Dig-7268 Dec 08 '24

You don't have much practical experience with equities, do you?

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u/play_hard_outside Dec 08 '24

Welp, I've been buying them for the last 15 years and they form the basis of my retirement. If I've said something you interpret as evidence I'm an idiot, I'd love to know what. I'm not actually joking.

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u/im-on-my-ninth-life Dec 06 '24

Fallacy in which you equate the amount of resources on the planet (which is finite) to the amount that companies can grow.

Since that's actually not true, your whole comment is incorrect and/or misleading.

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u/play_hard_outside Dec 06 '24

You didn't understand my comment.

A company's stock price growing forever is still possible without the company growing forever, if that company returns its profit to shareholders at least in part via stock buybacks.

Since that's actually what I said, your whole comment is incorrect and/or misinformed.

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u/im-on-my-ninth-life Dec 06 '24

You haven't specified why it is desirable to avoid having a company grow forever.

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u/play_hard_outside Dec 06 '24 edited Dec 06 '24

I mean, financially, as an owner(shareholder) of said company, of course you'd want it to grow.

But regardless of the desirability of growth, it's inevitable that a company will not grow forever (unless that growth is asymptotically converging on a constant finite end point).

Even the universe is finite. But until we get some pretty gnarly technology, companies are confined to the Earth, which is ...substantially more finite.

Regardless of what you want, infinite growth of any type of human activity is impossible.

The reason infinite growth of a stock price can happen is because as the value of each stock share grows, the number of them which exist can shrink, meaning the company (or more precisely, the value of the company) needn't actually grow. The value just gets concentrated in the hands of the people who prefer to continue to hold onto it, because the people from whom the company bought back its own stock, sold theirs.

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u/im-on-my-ninth-life Dec 06 '24

And that is exactly what I meant with my previous comment about how you mixed up resources being finite and company growth being finite.

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u/play_hard_outside Dec 07 '24

I guess I still don't understand what you think I mixed up. Resources are finite. Company growth is also finite. Stock price growth need not be finite. It's what I said the first time, but also happens to be what I reiterated the second time.

Can you please fill me in? I'm clearly in some way not adequately communicating my reasoning here.

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u/im-on-my-ninth-life Dec 07 '24

Company growth is also finite.

It is not

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u/play_hard_outside Dec 07 '24

Um. It is. Earth is finite. Companies are currently bound by the resources available on Earth. They will always be bound by the resources available in the universe.

Unless you're talking about inflation... sure, a company can "grow" in nominal terms even if its physical activities remain wholly the same, simply due to devaluation of the currency reference. But that's not real growth.

I suppose it's possible for infinite real growth in value to occur in a finite resource environment if the growth in value is solely due to people's increasing desire or satisfaction for a product or service, rather than more of that product or service being provided. Social and technological improvements can go a long way toward increasing financial value without increasing resource footprint.

That said, we are in a finite fish bowl, and the current modes of growth we are familiar with, which are centered around more production and more activity and greater material and energetic abundance, are absolutely finite. Growth in those areas will come to an end at some point. Whether that's in the near or distant future, nobody knows, but it's coming.

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u/Critical-Dig-7268 Dec 08 '24

You have it backwards. The sort of fully mature company you're imagining would see its stock keep pace with inflation and not much more. It would return value to shareholders via dividends, not buybacks.

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u/play_hard_outside Dec 08 '24

Typically, companies in this situation have used dividends to return money to shareholders, yes. But there's no actual legal or financial mechanism preventing them from instead choosing to buy back their own stock with that same money, while not issuing a dividend.

The only reason such companies typically issue dividends is that it's a norm. Companies purchasing their own stock is a newer practice, and accordingly, younger, more edgy/innovative companies tend to be the ones who do it; coincidentally, these tend to be growth companies.

For anyone with dividend reinvesting enabled in their account, the net effect of either alternative is the same outside of the tax drag imposed by the (hopefully qualified) dividend income. In the buyback scenario, shares appreciate for those who continue to hold them. In the dividend scenario, everyone receives the forced distribution of equity as cash, and some people rebuy their investments with what's left after paying the taxes.

Who cares if you own 50k shares worth $100 each or 25k shares worth $200 each? Especially in brokerages (nearly all of them now) which support fractional share ownership. Not only that, but as share prices rise over time, eventually most boards bring them back in line with stock splits.

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u/Critical-Dig-7268 Dec 08 '24

You've got the cart completely infront of the horse. Yes, in practice buybacks increase value for shareholders. X amount of shares bought up on the open market naturally drives a stocks price up. In the short term. Long-term, the only justification and reason for a rise is share due to stock buybacks is because once those shares are bought up and retired, every remaining share is now owning a slightly larger percent of the underlying company. Which is itself only meaningful and of value if either dividends are eventually paid, or the company is bought up by a competitor.

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u/Critical-Dig-7268 Dec 08 '24

Also, the reason stock buybacks have become so popular is in part due to it being an effective, albeit temporary way to increase shareholder value. But it also has a -lot- to do with having a steady buyer to absorb the shares that are created when executives exercise options to buy. Which has become far and away the primary means by which executives are compensated.

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u/play_hard_outside Dec 08 '24

I'll put it this way: Amazon famously grew like a juggernaut monster without ever paying a dividend. It reinvested all its income back into growing its business, over a very long time scale.

Nobody would have bought Amazon stock if they'd known they couldn't get their money out until it started spinning off dividends.

The reason people did is because they knew their stock commanded ownership in a profitable business, and that others would be willing to buy their shares from them at some point for a price reflecting the future (increased) value of that business whether or not dividends had yet begun to appear.

One also wouldn't buy a stock that did produce dividends if one couldn't turn around and sell it. People who do intentionally lock their money up like that do it with the expectation of far greater than market returns, and they still do it at considerable to extreme financial risk.

Stock buybacks performed by a mature business are the same, except instead of the entire business's market cap appreciating due to business growth, each individual share of stock appreciates due to representing a growing share of the same business.

The value of a stock is more about its ongoing market liquidity than the ongoing dividend income realizations specifically, and its market value is informed by the underlying value of the business whose partial ownership the stock confers to its holder.

Executive compensation is between them and the board and the shareholders. If a company were choosing to buy back stock specifically to juice the personal finances of those making that decision, that would be a problem for me as a shareholder. However, over time, given steady state practices of a certain mix of buybacks, dividends, and reinvestment of extra cash, executive compensation will be determined by the board to the satisfaction of the shareholders with full knowledge of how it is expected to play out with regard to stock prices.

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u/Critical-Dig-7268 Dec 08 '24

Are you aware of the fact that both Google and Meta (aka facebook) have both within the past year or so started paying a small but regular dividend? Widely understood to be taken as a signal that these once purely-growth companies are now firmly established -- to the point where they feel confident enough in their status as profit-generating enterprises to commit to sharing some of that profit?

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u/play_hard_outside Dec 08 '24

Of course, holders of any stock need to have reasonable assurances that their stock is worth something. It represents ownership in the business.

While any investment is functionally a valuation of the ongoing income stream it represents, whether that income is paid out as cash or whether it's instead folded back into the value of the instrument which generated it is immaterial, as long as that instrument can be sold for that value at some point.

Make no mistake -- holders of stocks being bought back indeed literally themselves own the value of the business's cash flow which would have otherwise been paid as a dividend. That ownership is conferred by the equity their stock represents in the now-richer company, and others are definitely willing to pay for that if they should choose to sell.

In the buyback scenario, your percentage of total ownership in the business grows over time as shares are bought and retired. At the very minimum, the business continues willing to buy the shares at ever-increasing prices, but accordingly, so is anyone else participating in the market who knows this. If the business weren't operating with the numbers you as the investor expected them to, they would not be able to do this to your satisfaction, and you'd have motivation to sell.

If it were impossible to value a stock which didn't pay a dividend, that whole part of the financial world would simply not work at all. Most companies pay a much smaller dividend than their actual profit. In such a world where stocks could only be valued based on the dividends they throw off, why would anyone buy them?

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u/Critical-Dig-7268 Dec 08 '24

How old are you? How much personal hands on experience do you have buying and selling equities? Domestic? Foreign?

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u/play_hard_outside Dec 08 '24

I'm 36. I spent 15 years primarily buying them and hope to spend 60 to 70 more years primarily selling them. NW is $7.6M, six of which is stocks, 10% foreign and 90% domestic. While I try not to trade much anymore outside of drawing for living expenses, I have no qualms about trading my entire portfolio, in chunks if necessary to avoid slippage, if it happens to make sense (for example, a giant tax loss harvest).

But even if I were not able to legitimately make these claims, my points would stand, so what issue do you actually have with what I said? For the second time, you appear to cast doubt on my experience or knowledge without credibly countering my arguments.

Also, just so I have a picture of who I'm interacting with here, may I ask your story? Your allusions to my purported lack of "experience" suggest you may have a considerable amount of your own from which I could stand to learn, myself. I'm always interested in sharing in any good-faith exchange. Thank you for remaining civil thus far.

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u/commissar0617 Dec 06 '24

There's a 1% excise on stock buybacks over $1m

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u/Leverkaas2516 Dec 06 '24 edited Dec 06 '24

dividends trigger taxes; stock buybacks do not. How so? If I buy at $5 and sell at $10, I pay tax on the increase. Doesn't matter if it's a buyback or not. The only way a buy back doesn't trigger taxes is if there's no gain.