Tuesday, May 25, 2010

Problems with profits

In a comment on Sunday Essay - threads in Belshaw thought, Ramana wrote:

 having been a professional manager with hands on experience of the planning process and facing the music for actual delivery, I am convinced that it is a total waste of time. The best that one can do in business is forecast for the short term to plan for needed resources, innovate as you go along and keep delivering a constantly improving bottom line.

I have a lot of sympathy with Ramana's position. However, in responding, I also said in part:

I do have real problems, however, with one point you made, the idea of a constantly improving bottom line. I now question whether this is either a desirable or achievable business objective.

I don't have time this morning for a proper post, but I did want to flag this issue.

Without going into full details at this point, my concerns can be summarised this way:

  1. Profit itself is not a clear cut concept. Leaving aside definitional issues, do we define profit as profit at a point or sustainable profit over time?
  2. Profit as a share of GDP fluctuates, but over time tends to grow around the rate of growth in GDP.
  3. In a competitive marketplace, above normal profits earned by particular firms tend to be eroded through competition.
  4. If, as is presently often the case, the sum of present and future profit projections by individual firms exceeds the total profit share by a significant margin, then it follows that the majority of firm's projected profits are unachievable. Worse, in trying to achieve them, they are likely to substitute short term gains for longer term profits.

To illustrate this, consider price/earnings ratios.

These used to be expressed in terms of the ratio between price and profits in the preceding period. I could understand this. The only judgement that I needed to make lay in a decision about the sustainability of past profits.

Now P/E ratios are based on projected profits. Since I know that profits as a whole must fall short of projections, it follows that the majority of P/E's will be wrong. They provide no guide at all.

See what I mean?    


lemmiwinks said...

I agree about the constantly improving bottom line. Why? Why is it not enough to simply make a profit (surely the aim of businesses), why must they constantly make a larger profit than previously? How can that ultimately be sustainable?

Anonymous said...


Ramana's comments were as realistic as they were unremarkable and, I expect, born out of long experience. This is a simple fact of (commercial) life that may not gel with your wider societal or ethical concerns.

This year's 'profit' - however defined - must exceed last year's profit. If not, you are not managing, you are just getting by - or more likely, going backwards.

(Can't remember seeing any bonus or share option schemes based upon just getting by - and taken to extremes you get Bernie Madoff, the China milk scandal, and Conrad Black)

I think Ramana is perfectly correct in his comments, and your conclusion to your point #4 "likely to substitute short term gains..." is just another statement of sad commercial reality. And I do understand you were not making the point with that in mind.


Jim Belshaw said...

Part of the problem, LW, comes back to the way profit is defined as well as the emphasis placed upon it.

Firms have to make profits to give a return to shareholders and to fund future investment. If that investment is done sensibly, total profits should increase, but not necessarily return on total assets.

There is nothing wrong, either, with firms seeking to increase profits measured by return on investment. That's normal.

However, when maximisation of short term profit measured in absolute terms and by ROI becomes central, when the totality of firm targets exceeds what is possible by a significant margin, when the firm is judged in market terms by its failure to deliver on forecasts, the system becomes unstable, profits unsustainable.

With a stable ROI, you can increase earning per share by borrowing, for example, so long as the cost of borrowing is below ROI. You may also increase earnings per share in some conditions by buying shares back. Both have their place, but also their problems and their limits.

To my mind, the biggest problem of all with an obsessive focus on profits is the damage done to staff, to customers and to the longer term survival of the business itself.

Jim Belshaw said...

Hi KVD. Your comment came up while I was responding to LW. I am not concerned with ethics on this on, but with results.

I stand to be corrected, but I know of no evidence that the current approach actually increases other than short term profit however measured. Further, there is a fair bit of evidence that most of those firms who make increasing profits central actually underperform.

There! Now I have to cook dinner once more. I look forward to your comments!

Anonymous said...

Well! I think I would much prefer to be sitting down to your dinner, than to be responding to your comments.

Your “Problems with profits” post started with a highlighted comment by Ramana with which I found myself simply nodding in agreement as a statement of the obvious. Then in your latest comment you said “I know of no evidence that the current approach actually increases other than short term profit however measured” - and again, I just nod in agreement – because from the manager’s perspective, what other objective can there be?.

Jim you may correct me on the statistics but my present understanding is that ‘managers’ – be they MD’s of banks, or Klopper of BHP, or Fred at the local Bunnings – have a limited “life” (5 years or so?) and are all very engaged with short term performance because that is how they are rewarded.

To say this is either “right”, “wrong” or “not in the best interests” of the commercial entity is simply to deny the commercial reality that they are judged in their present job (and for future jobs) by their short term performance. Ramana put it better, simpler.

I am not disagreeing with your longer term analysis and goals, but I am suggesting that we probably won’t see a Gail Kelly tell her board “look, you won’t see an improved bottom line immediately, but hang in there – in 20 years time you will thank me; of course I’ll be retired by then with my options, but it will work out”.

My response was about commercial reality, as opposed to what might be “best for us” in the longer term. But maybe I misunderstood; and maybe the sky is pink. But dinner would have been short term good.

ps P/E ratios are just historical artefacts. Fear/Greed is the "new now". And the LIBOR rate is rising...

Jim Belshaw said...

David, I should have fed you! Roast beef. More later.

Rumuser said...

Net profit per se is a meaningless figure unless it is related to it being a return on the investment made. For instance, a low margin high turnover product can generate very satisfactory returns on the investment made, with prudent working capital management. On the other hand, long gestation project revenues have to reflect very high profits on a cost related result as, the working capital and other forms of capital are locked up for very long periods with usually low cash inflow during the duration of the projects. The point that you make that the P/E as projected is not worth the paper it is written on is absolutely correct. It is usually done to satisfy some reporting system which is used by the Board to indulge in some PR to push stock prices up. Anonymous is right in that this is what makes managers short term driven. Owner managed enterprises, particularly small and medium sized ones, do not suffer from this malady.

Jim Belshaw said...

Absolutely agree, Ramana. Profit characteristics do vary depending upon the lead times and on the sector. Current reporting requirements do lead to short termism.