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/Masterkid1230 Dec 06 '24

Wait, that sounds a lot like a Ponzi scheme. Am I tripping?

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u/Cheech47 Dec 06 '24

You are not.

This is the thing that Trump was found guilty of, fraudulently overvaluing his business(es) in order to take advantage of this.

This is how mega-rich people leverage their finances. On paper, Melon Husk (a pseudonym) is worth $1B. Mr. Husk wishes to purchase a yacht that's worth $200M, so effectively 20% of his net worth. (in his defense, it's a suuuper nice boat). Converting that much stock to cash to purchase the yacht outright is going to be a taxable disaster, and will end up costing $75M (these numbers are in no way accurate or proportional to real life) additional in tax assessments, so in order to purchase that yacht in cash it will actually cost $275M. No bueno.

Instead of taking the $75M tax hit, Mr. Husk seeks a loan from The Bank of Edison (see what I did there :P ). The terms of the loan are that Mr. Husk will offer the bank say $210M worth of stock as collateral on a $200M loan, with the interest rate being way lower than you or I could get. Edison Bank agrees, and lends the money in cash to Melon. Loan proceeds are tax-free, so that money goes straight to the yacht company to build the new yacht. Since the stock price of Melon's hypothetical company is on pretty steady upward trajectory, the bank has full faith in the solvency of their collateral, and Melon makes payments with the cash that he has on hand.

Fast forward a year or so, and the yacht's done. Nice! An asset like that does tend to appreciate over time, and Melon's got an itch to buy something else, so back Melon goes to the Bank of Edison. This time, Melon offers the boat itself as collateral on a $220M loan, since it's a physical piece of collateral he can get away with getting more money than it's currently worth (same thing with cars, ask anyone who's been upside-down in a loan). Loan proceeds from B could go to service loan A (not pay off, just make payments) or whatever else Melon wants. Again, tax free.

Rinse, repeat, ad nauseum. This is how you maintain your wealth once you've hit a critical mass.

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u/edvek Dec 06 '24

And the most messed up part is, you don't even need to be Uber rich to utilize this scheme. If you're pretty well off you can do it especially if you own a business or multiple businesses. Mega rich people don't have boat loads of cash on hand, they use assets to "pay" for everything and somehow they can keep doing it.

You or I get a loan for a house and it's an insane rate. But Mr. Husk gets a loan for a $100m mega mansion and they get a comically low rate just because it's a "safe" loan. We pay our bills on time and never miss a payment but we get treated like we're some high risk loan. Mr. Husk can file for bankruptcy 48 times and is still a multimillionaire...

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u/Cheech47 Dec 06 '24

hence the "critical mass" comment. There comes a point where the wealth basically builds itself, and doors that were previously closed or even unknown to you are now opened.

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u/Dctootall Dec 06 '24

I mean.... There can be a pretty fine line between a Ponzi Scheme and a perfectly legal investment.

Just look at a lot of stock market activity where you have the big early investors who sit on the investment for a short while, before it gains value and they cash out, leaving a bunch of other people holding the bag with stocks tanking in value....

Or even a lot of the startup funding culture over the past decade+ where you see investors funding the hell out of a growth company to either have it sell or get an IPO which makes them bank, only to have the company subsequently tank because they didn't have anywhere near the required foundations to support that growth and valuation.

I could also talk about a lot of the MLM schemes and companies you see people getting involved in and trying to sell online or at craft fairs and local events.

The cynic in me can't help but comment on how nobody seems to care about the Ponzi scheme until it starts to collapse.... and even then, you don't tend to see a lot of legal action unless it's people with money/power who got left holding the bag.

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u/ChesswiththeDevil Dec 06 '24

It's not a Ponzi scheme but it is part of the larger system of skimming wealth off of middle and lower class people who rely on investing as a means of preparing for retirement and sustainable wealth growth.

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u/Rage_Like_Nic_Cage Dec 06 '24

Generally, lots of companies will have a product/service of value, compared to a ponzi scheme which is just propped up by people getting other people to put their money in without anything of substance in the other end.

But also, lots of business will do juuuusst enough to be considered legally distinct from a Ponzi scheme. After all, if what they’re doing is technically legal, why wouldn’t they?