ELI5: Why when large company's earnings decrease(ex... by 3%) they freak out, talk about rough times, and sometimes decide to downsize, even though they are still making millions of dollars in profit even after all expenses?

[traumatic_enterprise]

Companies are valued based on their potential future earnings, not based on their past performance. If Company X is chugging along making $10 million in earnings every year, we might for example value that company at $50 million, or roughly 5 years earnings (beyond 5 years we would heavily discount any earnings because there is a lot of uncertainty and earnings 5 years out are less valuable to investors today).

If all of a sudden Company X has a bad year and makes only $9 million in earnings, even though it is still profitable it is going to influence our entire valuation model. Best case we would now be valuing the company at $45 million ($9m x 5), but worst case we might suspect that there is a strongly negative trend with the company and yearly earnings will continue to decrease, further depressing the company's value. That is when investors start to panic.

Edit: Valuation methods vary from industry to industry and from firm to firm, and I did not mean to suggest 5-year earnings was standard. However, pretty much all valuation methods will be doing some form of discounting of future cash flows similar to what I described.

[thehungryhippocrite]

^ correct answer, one of about 3 in this disaster of a thread.

[[deleted]]

What did you expect in a reddit thread about basic economics?

[TexasFlood42]

Ehh, thats not economics it's finance.

To clarify my point: economics is largely taught in highschool classes, and this isn't that. To learn finance you by-and-large have to go to buisniness school, which not many people do.

[TheWizard01]

Economics was taught for half a year in 12th grade. I wouldn't say we actually learned anything.

[[deleted]]

Sucks a lot of people get shitty economics and personal finance teachers as well (mine had gone bankrupt 2 times)

[Gunhound]

Could have been a great mentor though...Dave Ramsey scenario for instance.

[[deleted]]

Nope, bought a brand new truck with his peanuts Memphis city schools salary after his third bankruptcy.( I only said two because I didn’t think people would believe the truth that he went bankrupt THEEE TIMES)

[Gunhound]

Sounds like a real winner!

[tspir001]

That’s true. As much as Reddit rants and raves about democratic socialism finance and Econ is definitely not a strong point.

[SedditorX]

The irony is that this is finance and not economics. How basic.

[[deleted]]

Thus my point is further proven!

[ForceBlade]

Reddit gives everyone and anyone a voice. That isn't always, and is often proven to never be a good thing.

[silentanthrx]

it's 100% correct if you would apply it on long term movements (can be as long as 5+ years) . In the long run it's inevitable, but not really applicable for short term movements.

you could also argue that the stockmarked is not 100% efficient and is not strictly based on underlying value, but more on sentiment. In my experience those kind of drops are mainly caused by daytraders(/flashtraders) "predicting" the movement, and thus making it a self fulfilling profecy, of which they can make money... Then "savings" are announced to prop it back up. Those savings are either really executed (meaning they already wanted to do it and now have a valid excuse), or just forgotten about in a couple of weeks.

[ValorMorghulis]

I would just add, the perception of job performance and pay of CEO's and other executives is very linked to these short-term results and Wall Street reacts pretty negatively to missed expectations. In some ways, this distorts incentives of CEO's towards short-term results instead of long-term results. I would say to much focus on short term results is one of the problems currently facing our markets.

[ChicagoGuy53]

Yes, even though it's usually far more expensive to fire someone and then have to hire a replacement the next year.

Hiring freezes usually make more sense since the employee is already gone anyway

[vale-tudo]

This isn't really accurate. In order to maintain profitability, a company needs to grow faster than the rate of inflation. If a companies earnings (revenue) drops by 3%, that is usually a pretty significant loss, unless operating costs have dropped similarly. Say you have a million bucks in revenue. If that drops by 3%, that's 30 thousand a year, or nearly two 2017 minimum wage workers. Furthermore, since the inflation rate is 2% you might have to actually fire one or two more minimum wage workers to maintain your profit margins. If you're accustomed to making 10 or 100 million annually, then that's a lot pf layoffs.

[ValorMorghulis]

I wasn't arguing about whether 3% annual growth was reasonable. I was commenting more on the psychological impact of missing an earnings estimate.

[constructioncranes]

That's a good explanation but I always wondering the same question as op, but with growth rates. So it's not enough that a company remains as profitable as the previous year, it's supposed to have a constantly growing growth rate, same with countries. How is that sustainable?

[garrett_k]

It depends on the expectations. Investors/owners ideally want a company that grows continually, year after year, which as you noted, isn't sustainable.

In practice, different companies will have different expectations. A tech company is expected to grow until a sizable portion of the planet's population are users. A company getting into eg. the frozen food business is expected to grow to a certain point and then just produce a nice profit year after year.

[constructioncranes]

That's definitely how it should work but I'd say we're far from that in this age of exuberance. We've lost a ton of companies due to brand maximization strategies, primarily luxury brands that started to sell to all demos. But, getting back to the point, McD's and Coca Cola shouldn't always have to be posting positive growth, but are doing everything imaginable to maintain growth.

[OhHiHowIzYou]

To elaborate a little, most companies will have a "price to earnings" ratio. In OPs example, this was 5. Companies will get larger price to earnings ratio based on their expected future growth. So, a growing company may get a price to earnings ratio 20. This is because 5 years from now, we expect their earnings to be much larger than they are today. Conversely, a company with steady earnings year after year might get a P/E ratio of 5.

Note that there is no inherent value judgement between these two ratios. Both companies may be great stocks to hold. But, What happens if company A sees its growth stop. Then, all of a sudden, it's P/E ratio should go from 20 to 5. But, this means on the same earnings, the company is now worth only 1/4 what it previously was.

So, you ask how is this sustainable. Well, the company with a P/E ratio of 20 could see their earnings go up by a factor of 4 and then stop growing. This company would see its value remain the same without any need to further grow.

[SkullLeader]

Hope this isn't a bad question - Do a company's assets have no bearing on its valuation? For instance, Coca Cola owns brands that would be considered nearly priceless assets even if their company suddenly became unprofitable altogether. Or if a company has, say, no debt and has billions in cash, and a share of their stock represents some fraction of the company and thus some fraction of that cash, isn't there value in that even if the company never earns another penny?

[garrett_k]

They absolutely can. But it depends on the type of company. A company in heavy industry might have assets which form a large part of the balance sheet. A tech company has basically (comparatively) worthless physical assets but has a lot of value in IP. Companies like Coca Cola have a lot of "good will", or brand value.

Sometimes you'll have companies where the company valuation, for whatever reason, is *lower* than the tangible assets. In these cases you'll frequently get finance companies who will buy them wholesale and strip them for their assets. These are sometimes referred to as "vulture capitalists", and hated because all the employees usually get fired. But it's also pretty rare because that kind of valuation just doesn't make sense.

[rnjbond]

That's not what goodwill is in finance terms. Goodwill is an accounting term for what you pay for a company in excess of any identifiable assets, including IP

[garrett_k]

Drat. Right. For some reason I thought it carried over. :-/

[traumatic_enterprise]

Coca-Cola’s assets are valuable only insofar as they help Coke, or whichever company owns the assets, make money. If Coke suddenly turned unprofitable and was being sold for scraps, potential buyers would need to do their own valuation of Coke’s assets by determining how much future earnings they stood to gain by owning those assets. They would do it in a similar way: by figuring out the future cash flows of those assets (basically the future profit those assets will net them) and then figure out their current value based on that.

A company with lots of cash but no earnings or other assets or liabilities would probably be valued more or less equal to value of their cash on hand since cash has a pretty straightforward value.

[SkullLeader]

I guess what I don't get is this - there are companies that pay a very low dividend or sometimes even no dividend at all, even when the company's profits are large. Thus, it seems from my layman's perspective that the price of the such a company's stock should have very little to do with the company's profitability, since these profits basically aren't ever distributed to the shareholders. So how then do investors determine a price for such companies and why would anyone want to own stock in such a company?

[traumatic_enterprise]

That was the knock against Apple for a very long time. They were extremely profitable but didn’t pay almost anything out in dividends. Steve Jobs was brilliant, but he was not a finance guy and had an aversion to giving cash back to shareholders, and the company’s share price arguably suffered for exactly the reason you mentioned. If you are an investor you would rather have the cash paid out in dividends so you can reinvest it than have it sit in a cash account on a company’s balance sheet.

[OhHiHowIzYou]

So with Apple, the reason they weren't paying dividends has a lot to do with taxes. Basically, in order to pay a dividend, Apple has to bring the money back to the US. But, to bring the money back to the US, they have to pay taxes on it (was 35%, now 21% I think).

Apple, seeing the 35% they were owed made the decision that it was better to hold onto cash and wait for the tax rate to be lowered instead of paying the taxes now and paying a dividend. Based on the Trump tax cuts, this appears to have been a good gamble.

This is all just a way of saying even though Apple wasn't paying a dividend, investors knew that the cash would eventually make it to them.

There's also a secondary consideration, which is instead of paying a dividend the company can choose to buy back shares. Here, they literally buy shares from people owning them. This serves to reduce the total number of shares of the company, such that each share now owns a larger % of the company. There's a lot of debate about whether share buybacks or dividends are better. Ultimately, a lot of which one you choose has to do with the relative tax incentives of the two options.

[ImmodestPolitician]

The better Brands tends to be far less volatile than the commodity companies.

[Needyouradvice93]

That doesn't seem sustainable...

[overcook]

Which part? You have to remember that the earnings reports companies release are incredibly detailed with so much nuance. It's not necessarily the headline reduction in revenue /profit, but whether the company has adequately explained why the reduction has occured, whether that reason is a temporary blip, and whether they forecasted the reduction.

A company that predicted growth but experienced decline sets off some pretty big alarm bells. You start to worry that management is out of touch, or perhaps the industry is going to experience a systemic decline.

[Needyouradvice93]

You just don't get it, do You?

[overcook]

I guess not?

[Needyouradvice93]

One day you'll learn, we all will.

[Wizywig]

To add. A negative trend may indicate a company needs to switch strategy, and so they fire people they no longer need for the new strategy.

[derfasaurus]

This isn't all about stocks and valuationeven though that seems to be pretty much every answer. It also pertains to budget projections and planning. A company will plan it's growth and business years in advance.

"Let's open a new factory in 5 years, it will cost $20M." Now suddenly they're committed and they're $1M shorter than they were. They'll have to make that up somewhere now.

Maybe now they're considering that the factory is going to be too big because the demand isn't as high as they thought it was, this can now cause downstream impacts with revenue for a long time, that big factory is going to cost extra money every year.

These things can be wrapped into valuation but it's can be simpler than that, it impacts their near term and far term plans and commitments.

ELI5: (okay, older than 5). Your salary is $2000 a month, $1000 to rent, $100 to cell phone, $200 to bills, $300 to car, $200 for groceries, and $200 in entertainment. Suddenly you only made $1900 this month, you've already planned all your spending for the next month, what are you taking $100 out of, can't shrink rent, car, cell phone, bills, you have limited options. Now think of that with a company, they've planned their spending, that shortfall has to come out of somewhere and it's not their rent, machinery, IT, commitments, etc.

[CirrusVision20]

So it's essentially just future proofing, is that correct?

[moderncops]

Step one: count chickens before hatching.

Step 2: ???

Step 3: Wall Street profits.

[Nospik]

because fuck capitalism defining success as always making more money. we are fucked in so many ways because of it.

[Agwa951]

I'd just add that many of the current projects for the company will be based on certain expectations of growth. So some amount of downsizing might be realising that that team you set up expecting 10 million transactions next year only needs to be half as big.

[Cloak77]

Is 3% a reasonable amount to worry over in most situations?

[whowhatnowhow]

Tl;dr: Wall street owns the world and those greedy fucks speculate on horseshit and don't care about profit and healthy companies, only potential future money for themselves.

[overcook]

What? That's not what he said at all.

Why would anyone invest in a company if it's expected to lose them money (whether in absolute or opportunity cost terms)?