Why do companies have to make more money each year?
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Listener Louis asks:
Why do companies always have to make more money each year? Why is it considered a failure to stay flat year to year, even if the previous year was considered a good year?
In the first quarter of 2014, Apple, one of the world’s biggest tech companies, raked in a whopping $13.1 billion in profits — enough money to pay for the latest round in COVID-19 aid and the Denver Broncos three times over.
But those profits were flat, compared to 2013, which sent Apple’s shares down in after-hours trading.The example highlights a longstanding reality in the corporate world: pure profits aren’t good enough. Investors want the promise of growth.
There are a variety of motives for a company to rake in higher revenues and make bigger profits year over year, including efforts to keep up with inflation and appease investors. Let’s start with that first basic reason (a timely one): inflation.
“Say general prices in the economy are going up by 3% a year. You would want your revenues to grow by at least 3% a year,” said John Graham, a finance professor at Duke University. “So keeping up with inflation is a form of growth that just means you’re treading water.”
Companies also want growth to reflect the rising U.S. population, Graham added. He said if the population of a town with a couple of hardware stores grows by 2%, their sales would, ideally, go up by 2%.
Value also begets value. So if your company is growing year in, year out, people might assume, fairly or unfairly, that your company is better, Graham explained. If you’re a publicly traded company, he added, that perception matters because your stock price might go up.
Then there are investors who, yes, expect returns, said Jennifer Koski, a finance professor at the University of Washington.
“The way I get that return is if a company grows. If I’m just gonna get my safe flat return, but it’s not a risk, I would much rather put my money in the bank,” Koski said.
Private companies, too, reap advantages by growing.
“When you’re growing faster, a bank might lend to you at a lower interest rate,” Graham said — they trust you’ll be better able to make your loan payment.
Bigger companies tend to have advantages over smaller companies because of economies of scale. Large companies can get discounts by being able to buy in bulk, save money through efficient labor practices and hold more negotiating power, Graham said. Then there’s market power, allowing companies to have greater control of their own pricing, he added.
Growth also comes at a cost.
“For a company to grow its profits, the company has to make investments in things like new factories, and those investments are not free,” said Luke Taylor, an associate professor of finance at the University of Pennsylvania.
Growth can come at a cost to middle-class jobs and wages, too. Marketplace’s “Price of Profits” series charted the rise of an obsession with shareholder value that continues to this day.
Graham noted that, in a twist, there are some companies whose priority hasn’t been on growing profits — initially. They’ve instead focused on becoming bigger, a strategy he thinks has increased in recent years.
“Think about Amazon. Remember how many years we heard they hadn’t made any profit yet?” Graham said.”What were they doing? They were just growing, growing, growing, growing until they were such a big force in the economy that now, finally, they’re … making a ton of profits.”
Graham pointed out the many companies going public now that have never made a profit. “The growth now is a promise of even more profits down the road,” he said.
Small businesses also face pressure to grow, but if they’re privately held and owned by one or two people, they may decide they’re fine with staying at one size, said Laura Veldkamp, a finance professor at Columbia University.
“Lots of independent restaurants, for example, might fall into that category of not growing, but owners being okay with that,” Veldkamp said. “They are sacrificing financial return for doing something they love. Nothing wrong with that.”
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