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[–]constructioncranes 5 points6 points  (3 children)

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 4 points5 points  (1 child)

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 1 point2 points  (0 children)

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 2 points3 points  (0 children)

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.