We spoke in the last lesson about profits. So, what are profits? They are defined as revenues minus costs, or the money left over after all of the bills have been paid.
Where do they go? Every firm has an owner, and these owners are the people who legally own the profits from the firm. People invest (put in) their money, their time and their effort in a firm with the hope that the firm will make a profit. Therefore, the profit is a payment to the owner of the firm in exchange for the things he has put into the firm. In a small business, the owner puts in time, money and effort. In a large, public share company (called a joint-stock company), owners only put in money when they buy shares. So, the money left over after operations, which is total revenue minus total costs, is what we call the "accounting profit," and this is the payment to the owner in exchange for making an investment in that firm.
How much profit should a firm make? To think about this, it is helpful to think about some choices you have as an investor. Let us imagine that there is an investment that is 100% safe. This means that you know for sure that this investment will pay the profit it promises to pay.
Let’s say this safe investment promises to pay 5% profit after 1 year.
Now, imagine another investment which is not 100% safe. In fact, 10% of the time, this investment vanishes into nothing. How much profit would this investment have to make to want cause you to invest? Phrasing this another way, what kind of earnings would you have to make on the "unsure" investment to make you indifferent to choosing it or the "safe" investment? By indifferent, we mean that you do not care between one or the other, because they are essentially the same thing. This is where we start delving into notions of probability, uncertainty, and expectations about the future.
Well, let us do the math:
For the safe investment, you will get back $105 for a $100 investment today.
For the other one, you will get $0 back 10% of the time, and $100 + X back 90% of the time. What does X have to be to make these two choices the same?
105 = 0.1(0) + 0.9 (100 + X)
105 = 90 + 0.9X
0.9X = 15
X = 15/0.9 = 16.67
So, if this other investment pays a profit of $16.67 on $100, then you should be indifferent to the two investment choices. That is, the two investments have the same Expected Profit to the investor.
When expressed as a percentage gain, this profit is called the Yield from the investment. In the above example, the yield from the second investment has to be at least 16.67% for you to be interested in making that investment. If it is higher (say, 20% yield), then you would prefer it to the safe investment. If it is lower (say, 10% yield), then you would prefer the safe investment.
Why does the second investment have to pay a higher yield? Because there is a chance that the investment will fail and pay you back nothing. This is what is called Risk. Risk is another word for Uncertainty: the lack of knowledge of what will happen in the future.
The profit from every investment has two parts: the risk-free return, and the risk premium.
Risk-free Return (RFR)
Risk-free return (RFR) is the profit you can make from an investment that has absolutely NO uncertainty. You know, for sure, that you will get paid a promised profit. Is there a risk-free (100% sure) investment? No. But there is one that is very close: lending your money to the US Government. The US Government borrows money by printing up pieces of paper called Treasury Bills (T-Bills). These are promises to pay a certain amount of money at some point in the future. For example, a T-Bill might promise to pay $100 one year from now. If you buy this T-Bill for $95 today, you are making a yield of 5.26% [(100-95)/95 = 5.26%]. This is considered to be the safest investment in the world. The chance that the US Government will not pay the promised amount on its T-Bills is considered to be so close to zero as to be equal to zero. So, for any investment, the risk-free rate is the return a person could get from buying US T-Bills.
Risk Premium (RP)
Risk premium (RP) is the amount of profit that is paid to compensate for the chance that the investment will disappear. In the example shown above, the risk premium is equal to 16.67% - 5% = 11.67%. Because there is a 10% chance that your investment will vanish, the owner of the firm will have to promise to pay you an extra 11.67% IN ADDITION TO the risk-free return in order to get you to take the risk. The riskier the investment (that means, the higher the chance the investment will vanish) the higher the risk premium that has to be paid.
Risk versus Reward
Risk versus reward is an underlying concept of the capitalist system: that a person who takes a higher risk expects a higher return. Thus, risk-takers are often people who make a large amount of money, but only after they have lost their money several times. The higher the risk in an investment, the higher the risk premium.
Expected Profit and Economic Profit
The expected profit from an investment is the risk-free return (RFR) plus the appropriate risk premium (RP) for the industry in question. So, the accounting profit (TR – TC) should be equal to (RFR + RP). If the profits are greater than (RFR + RP) then we say that an investment is making an Economic Profit. This means the firm is paying a yield that is greater than the yield for other companies with similar risk. We expect economic profits to always be moving towards zero. The reason for this is simple: if an investment is paying an economic profit, it is basically paying out “free money”: more money than a similar investment. So, what happens? Everybody will move into the “good” investment. There will be more demand for this investment. More demand means the price will go up, which means the yield will shrink. (Remember, yield = (future payment – purchase price)/purchase price. As purchase price goes up, yield goes down.)
This is the theory of Efficient Markets. This means that if there is a very good investment, everybody will want to invest in it, making it more expensive, and therefore making it less of a good investment. So, in the long run, we expect every economic profit to be pushed towards zero. The only way a firm or person can make positive economic profits over time is to keep their profits secret or their methods secret, and both of these are very difficult to do.
Think of the idea of opportunity cost. The opportunity cost is the value of the most valuable thing you did not do. So, when you invest your money, you will discover that there are many, many places where you can put your money. Which is the best one?
The profit you expect to make from an investment should be at least as good as the next best possible choice. So, the economic profit from an investment is the difference between the best choice and the next-best choice.
For this reason, we always expect the economic profit to be zero. Or, at least, moving towards zero.
Let’s say there are two choices of investment in firms in the same industry. In this industry, the risk-free return is 5% and the risk premium is 5%:
Buy stock in company A for $100 per share and earn $10 per year in profit.
Buy stock in company B for $60 per share and earn $9 per year in profit.
The profit on investment B is 15%, but in company A it is 10%. So the economic profit from owning B will be 5%. But, because of this, everybody will want to buy B. When the demand for a good increases, the price goes up, and in this case, the price will go up until the percent profit is the same as company A. The economic profit will be driven towards zero.
This helps us define how much profit a firm "should" make. In the first lesson, I counseled against "should" statements, because they are normative statements, and as objective and disinterested observers of the real world, we are only interested in "positive" statements. So maybe we can rephrase the question: how much profit does a firm have to make in order to make it an attractive investment? Well, we know that it has to make at least the risk free rate plus the risk premium. If it is making exactly this amount, it is making zero economic profit, and the investor should be indifferent to this investment and all others that make zero economic profit. If it is making more than zero economic profit, it is a very attractive investment, and because a lot of people will want to get at the "free money" that this firm is making, the stock price should go up, driving the economic profit to zero. The opposite will happen to a firm that is making negative economic profits.
The textbook author talks about "explicit" and "implicit" costs - explicit costs refer to things that a firm has to purchase in order to operate - paying wages to staff, purchasing raw materials and energy, paying rent and taxes, and so on. The other type of costs are implicit, and these refer to the use of the owner's resources - the owner's time and effort. This is the "return to the owner" I spoke of above. The return to the owner is equal to the opportunity cost of his/her time - the value of the best alternative use. Any business enterprise should be compensating the owners of the firm at a level that at least matches the opportunity cost of capital, on a risk-adjusted basis. If it does not, it makes more sense for an owner to invest elsewhere.
This informs us about the cost structure of a firm. When a firm is selling its product, it has to be selling at a price that is high enough to ensure accounting profits sufficient to generate enough of a return to cover the risk-free rate plus the risk premium - the payment that the owner must get in return for investing his money in the firm.
After working through the material on this page and reading the associated textbook content, you should be able to confidently:
- define accounting profit;
- define economic profit and understand its difference from accounting profit;
- understand what we expect economic profit to be, and why;
- understand the concept of risk in an investment;
- know what the two parts of profit from an investment are;
- understand what a risk premium is, and where it comes from.