What would happen if a companies profits just stayed the same over a period of quarters? I obviously don’t understand it at all but isn’t it just unsustainable to expect growth indefinitely?
In: Economics
They don’t need to go up every quarter, but investors want profits to increase every quarter.
The value of any company is directly proportional to its expected future earnings. If you purchased a share for 20x earnings and the earnings remain the same every year, you’ll reach breakeven in 20 years. A bit more than that, if you factor in inflation. If the profits increase a little every year you’ll reach breakeven a lot sooner.
Furthermore, investing in a business costs money. If your company reaches a profit of $1mn and you decide that you’re content with that and not attempt to increase the profit, you will have competitors that to try to increase their profit. They’ll market their business to attract new customers, change their offers to appeal to prospective customers, cut costs, etc. As their profits increase, so does their ability to invest in their business. And eventually, they may reach a breakthrough that enables them to provide a product or service that’s objectively much better than yours and you’ll go out of business.
As long as the economy and population are growing, there is the expectation of growth for a business.
If you aren’t growing in a growth environment it means that you are losing market share to competitors or your product/service is becoming less popular/relevant (maybe both).
There is actually a **very good reason** for this.
Imagine that you are CEO of a savings account.
The savings account bears 5% interest.
You start with $100.
Your boss the shareholder is entitled to all of the profits ($5).
You want to be an important CEO, and you can’t get paid very much for being CEO of a $100 savings account right?
You claim to your boss (the shareholder) that you will be able to give them *more money* if they let you *retain* the profit for reinvestment.
So, you keep the $5 and now you are CEO of a $105 savings account which has profits of 5% x $105 = $5.25.
Earnings went up! If you retain profits they should go up *every year*. (The savings account gets bigger).
Now imagine that you kept the $5, but you took a salary of $10. So the savings account now has $95, so “profits” are $4.75.
If you’re the shareholder that allowed the CEO to keep your money on the basis that they were going to reinvest it *how pissed are you?*
Tl;Dr – Shareholders don’t care if profits go up every quarter. However, *nearly every* company holds back some of the profits shareholders are entitled to based on the *promise* that they will use those profits to produce more profits in the future.
It’s not indefinite growth. Inflation means that CURRENCY is shrinking in value constantly. $/£/€1 today is worth less tomorrow – guaranteed for the last… well hundreds of years. We actually implement financial measures to *ensure* it does (so that people don’t just hoard money, in effect) – the Bank of England aims for 2% at all times.
So if you DON’T increase your profits by at least 2%, what that means is that you’re making less money – your profits are effectively decreasing.
Of course, it ALSO means that you should just automatically give all your staff a 2% raise without them ever having to question it – or else they are losing money themselves. But that’s not always a given!
Inflation exists to promote money being spent, invested, used to buy assets or services, rather than hoarded. Inflation means that profits need to go up every quarter/year by at least the amount of inflation.
Indefinite growth is even the literal target of huge nations like those in Europe and the US.
This is more of a thing for publicly traded companies, who want investors to buy their stocks. In some sense, each of those companies is competing with all the other companies for investor dollars. Investors general want their stocks’ values to go up, and the best way to get your company’s stock value to go up is to show consistent growth. So continual growth is how you attract investors.
Short answer: companies don’t expect to have earnings grow every quarter. They simply try to grow, and sometimes/often fail. This is expected behavior. No investment professionals genuinely expect a company to eternally grow beyond keeping up with inflation.
The problem here is you have a false premise that somehow companies can easily CHOOSE to keep profits constant. Profits are the result of the activities of a company. Company activities are not constant. New products and services are developed, competitors enter the market, old products are retired, new technologies are discovered, laws change, machines wear out and need replacement or maintenance.
Other than really simple businesses, so many things need to happen to keep a company operating. A wrong decision, an unexpected technology, natural disasters, etc can all affect a company’s operations for better or worse. Execution is uncertain so most of the time a company sets up slightly ambitious goals knowing that some come to fruition and others may not. If a company aims for zero growth, then any unexpected adverse event means missing their goals. A good company with a good track record naturally gets it right more often than not and grows.
Your idea of how companies work is a bit naive.
When publically owned, companies have to disclose quarterly reports to shareholders and the public. If those profits are routinely good, most people tend to want to buy stocks, which increases the trading price.
Privately held companies, either family owned, or private/angle investors only need to disclose reports according to the terms of the agreements, and never to the public. A private company actually has the ability to operate at a loss for a while as they retool and make longer term investments in themselves. For example in the early 2010s, after losing market share to the iPad, Dell took themselves private, invested a few years in design and overhaul, and came out in the mid 2010s with a better product line.
They don’t. Some companies have seen sales and profits drop over time. Tobacco companies are a good example, and have seen inflation adjusted revenues and profits fall over time.
But if you’re a growing company, you get to do exciting things. You get to hire more people, which means you can promote more of your own people, pay workers better, expand business, open new factories, try out new products, do innovative research, etc.
You can do all these exciting things- which are expensive- because you expect to be growing and your sales and profits will be higher next year- so spending more this year is fine, even if you go into debt to do it.
Most companies want to be exciting companies with increasing profits. Also- people want to work for exciting companies. If your company is shrinking, then some of your best employees might decide to leave for another company. After all, yours is shrinking or staying flat, so they’d rather work for a new company with the opportunity for growth.
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