Deseret News Archives,
Sunday, May 5, 2002

Edition: All
Section: Money
Page: M01
Length: 71 lines

Profits are not products of greed

I just heard someone complain about the "horrible" profits earned by businesses. According to him, if businesses are earning a profit they must be exploiting consumers and taking advantage of poor people by charging high prices.

Clearly this person does not understand the meaning of the word "profit." He must be thinking that profit is the money that gets paid to shareholders. He is wrong.

Profits are similar to the interest charged on a loan, except that entrepreneurs usually don't have to pay the equity investor anything. If they do pay something, it is usually less than 2 percent per year on the investment -- well below any interest the investor could have earned in other investments. And this despite the fact that the equity investor is taking substantially more risk than the debt investor because the debt investor has to be paid in full before the equity investor receives anything in the event of a bankruptcy.

Let me see if I can explain it more clearly.

Revenues represent cash received by a company. Cash is spent on salaries, supplies, plant and equipment, taxes, interest, debt principal and dividends. Operating profits are the sum of the cash spent on taxes, interest, plant and equipment (net of depreciation), net principal payments on debt and dividends. If the company has a profit-sharing plan, part of the money paid in salaries is also classified as profit. In addition, often the money a company uses to pay the salaries of engineers and scientists that develop new products, new drugs or new technologies is part of profits (if R&D is capitalized).

So if people are complaining about profits, they are mostly complaining about the money spent on taxes that go to the government, new plant and equipment, interest and principal on debt, research and development.

Less than 40 percent of all companies pay a dividend, and virtually no new companies pay a dividend at all. When they do pay a dividend, in today's market, dividends average only about 1.4 percent per year.

Many companies say they will never pay a dividend. The equity investor receives almost no cash from the company.

So how does the equity investor get a return? By selling ownership claims at a higher price than they originally cost.

Why does the share price go up if the company isn't paying dividends? The new plant and equipment or research and development of new technologies means that the share represents ownership in more assets and hence increases in value over time. As a side benefit, the new plant and equipment requires new workers, and so those "horrible" profits also create new jobs.

The equity investor is critical to the economy because she doesn't require a cash return. If she did, new companies, which desperately need all cash generated to grow their business, would never get started. New companies are spending so much on buying new assets to maintain their growth that they don't have any money to return to the shareholder.

Equity provides the flexibility the entrepreneur needs to use the profits to help the business rather than pay it back to the investor. Debt requires cash now. It is very inflexible and will cause bankruptcy -- and the subsequent loss of jobs -- if it is not paid.

So the next time you hear someone complain about profits, let them know that profits are not money going to greedy investors, but are really the money the government receives in taxes, as well as the money businesses use to buy new assets to create new jobs and new technology.

And who wants to complain about that?

Hal Heaton is associated with the BYU Center for Entrepreneurship. He can be reached via e-mail at cfe@byu.edu.

© 2001 Deseret News Publishing Co.