Interesting that private firms have 67% of employees yet only 20% of profits. Is this mostly because owners take “profits” off the books to avoid taxes, or because owners attend more to growing firm value than to paying current earnings?
That is a very large discrepancy, and neither the article nor its comments make a serious attempt to explain this very large difference. Here I will brainstorm a few explanations to see which ones make sense.
In his post, Robin presents strong evidence that suggests public firm managers lack the incentive to make long-term investments. An example given is:
As is common in factories, [public firm] Standard [Motor Products] invests only in machinery that will earn back its cost within two years. (The Atlantic, Jan 2012, p.66)
This is likely to be an important piece of the puzzle, and should be kept in mind.
Hypothesis 1: Selection, Entry and Exit
Any private firm of sufficient size can choose to go public. When do such firms choose to do so? The owners would do so when they prefer the price they can get on the public markets to the profits they can earn keeping the company private. Similarly, any public firm can be taken private, given sufficient funds and the willingness to pay a premium over the share price. Again, you would take a firm private when you feel you can create value by doing so. Many have suggested that a lot of what private equity does is to default on implicit contracts and understandings, but whether that is true or not firms should still be taken private when they are cheap and opportunities other than such defaults tend to be high, although highly variable profit from defaults could add variance and thus decrease this correlation.
Public firm value greatly increases as current profits increase, and decreases as current profit decreases, out of proportion to the amounts involved. A lot of this effect is the signaling effect, as failing to meet earnings goals that everyone will punish you for not meeting is a very bad sign that you were unable to meet them rather than strategically choosing not to (I hope to expand on how toxic that type of logic is in another post, and explore possible ways to escape or contain it). It has also been observed that in the past, buying “cheap” stocks and selling “expensive” stocks, across a variety of fundamental metrics, has been a profitable long term strategy in the American stock market.
Thus, relatively unprofitable firms, and firms with declining profits, are good choices to take private even before considering that they are likely to offer better opportunities for turnaround and improvement via investment and strategic change, which seems also true. Similarly, private firms that can expect to report strong short term profits are good candidates to take public because the markets will reward those profits disproportionately with a higher stock price.
It has been pointed out, as was noted in the comments of Robin’s post, that investors are capable of understanding when a firm is investing in the future, if the firm is engaging in a well-publicized and company-wide strategy for doing so, but such firms still face the same incentive problems on the margin: surprisingly good or bad earnings have a disproportionate stock price effect, due to investor impatience and/or the signaling implications, and the investment effects are hidden. The market seems to be far more understanding of this type of action when it comes in the form of growth rather than investment in other ways. A company that is growing its market share seems to get a lot more slack on profits than a company that is investing in fixing its machines to improve its long term outlook, partly because it’s a much harder signal to fake.
Right now, this leads to a class of technologically-based firms that are judged on their market share and potential future profits rather than current profits, but such firms tend to have very few employees. In addition, the successful firms of this type tend to be like Google and Apple, and have huge profits from small numbers of employees, while being far too big to be private.
Public firms are larger!
Large firms tend to pay better, on average, than small firms, and large firms are more likely to be public. If you’re paying your employees more, each employee is (on average) likely to be producing more profits. Small firms tend to be private, especially very small firms, and very small firms often face fierce or even close to perfect competition (or worse, such as with restaurants).
Small firms that could be profitable often have the choice to reinvest most, all or far more than all those profits back into the business; most start-ups function this way. While they are private, they make little or no profits. When they turn the corner and are profitable, they go public. If they didn’t have good investment opportunities to seek growth, they were likely to be not that profitable, and often labors of love.
It seems likely that we have a large selection effect via entry, exit and choice of corporate plans.
Hypothesis 3: Overvaluing of Margins
I believe there are a large number of companies in which margins are effectively a sacred value. I believe such companies are more likely to be public. Hasbro is a good example; at least at one point, any product that didn’t have a 15% margin was automatically old, busted and shut down. Departments and managers were judged on the basis of profit margins in addition to quantity of profit. Some firms sell off their ‘unprofitable’ divisions to make it look like they’re more profitable, even if often those divisions were profitable. Very large firms have at least one good incentive to work this way, in that there are efficiency costs to being too big or lacking focus, or not having the right customer-facing message, so divisions and product lines could be profitable and still worth selling even at a very low price.
Low margin activities aren’t ‘sexy’ either, and are viewed by markets with suspicion. They don’t look like a good business to be in. This makes public firms shy away from them, since they won’t help the stock price in addition to making mangers look inefficient. This also would be another way that public firms are encouraged to take profits now rather than seek investment, which would drive up current profits for public firms relative to their number of employees.
Concerns about margins might be a substantial effect, but they also might not be. I don’t know enough to say.
Hypothesis 4: Growing Firm Value
This is Robin’s first hypothesis and sees quite reasonable. A private firm can focus on long term value. Wizards of the Coast under private ownership can (and did) choose not to flood the market with cards in order to lay the foundation for a game that lasts for decades rather than milk the fad for what it’s worth back in its first two or three years, a choice that it would be unable to make now that it is owned by Hasbro. Growth and profits are both respected by Wall Street, because both can be objectively observed and their trends projected. If you’re investing in growth as a public company, you can make that work for you. But if you’re investing in sustainability of any kind, or anything else hard to observe, that’s different. It’s very easy to cheat on these effects to look good.
If a firm needs to invest large amounts of money in the future, and thus for a time be far less profitable than it could be, it would likely either go private in order to do so, or fail to do so and look profitable while staying public until it failed to achieve what it could have later achieved through investment. This is a combination of the entry and exit effect, and the growing of firm value.
One problem with this theory is that money is very cheap and has been very cheap for years, so if private firms had reliable huge investment opportunities, then we would see them taking large loans in order to pursue those opportunities. Why should ‘low profits’ be a typical optimization point when the interest rate is basically zero? This implies that the investment opportunities are not so huge, and thus should not be able to eat up the majority of profits either, limiting the effect size.
A possible explanation for that is to consider that a lot of growing firm value is likely to actually be about sustaining firm value. Building and keeping a good foundation is often the best investment you can make, especially in a stable firm like a store that has no reason to expand or become a chain. You want to not charge a premium that would anger your customers, even if they’d have to pay, but it would be pointless to sell at a loss. You would likely even make investments around the area to build a relationship with your neighborhood, which would eat into profits. You want to make sure all your machines are in good working order and replace or upgrade them when it would save you money, but you only need so many of them, and so on. This limits the bleeding.
The counterargument, of course, is that if private firms can make profitable investments that public firms can’t, then long term that should make them more profitable per employee rather than less, unless those investments come in the form of growth, and growth is considered respectable by Wall Street.
Robin’s post sites that private firms invest 10% of assets each year, versus 4% for public firms. A lot of selection effects are doubtless part of that discrepancy, and so is firm value. Private firms are not valued as highly, so they aren’t really investing 150% more. I know one private business that was sold for only $50,000, despite having multiple employees; them investing 10% of assets would have been very low investment, rather than a large investment.
My guess is that reinvestment matters, but is smaller than the selection effects.
Hypothesis 5: Regulatory Capture and Regulation in General
Private and public companies can both seek regulatory capture. It is easier for large firms to do this than small firms, and firms that succeed will usually get large and profitable, perhaps then going public. It would appear at first glance that investing in regulatory capture is a long term investment and thus hard for public companies to work at, and there’s likely some degree of that, but the size effects and selection effects are probably larger. A lot of the biggest firms are effectively collecting rents they got via regulatory capture. This disincentivizes them to make other investments, and encourages them instead to milk things for all they are worth since they don’t have to compete.
In addition, lobbying and regulatory capture are dirt cheap. Buying political influence is an amazingly profitable investment, and large firms have proven able to recognize this and spend money here even if the payoff is a little bit down the road. In addition, if you get a law passed, that’s hard to fake, so the value captured can be reflected in the stock price right away, and might even be encouraged by markets rather than discouraged. When Disney wins a copyright extension, its managers are rewarded very well, thank you.
Regulations usually favor the large firm over the small firm, as they add many fixed costs and impose costs on market entry, and make it harder for superior but less known products to win out.
A final note is that congressmen can do insider trading, and often do, so having your shares available for purchase provides a nice incentive opportunity that private firms lack.
I would guess that regulatory capture contributes to this effect.
Hypothesis 6: Tax Law and Tax Evasion
Tax law was suggested by Robin, and it definitely happens that firms go down this road. There are businesses that exist as tax write-offs, or which choose relatively unprofitable paths due to tax advantages. This could be considered a special case of regulatory capture that is more available to private firms, but that drives paper profits down rather than up. Tax evasion is of course available to private firms in ways it isn’t available to public ones, and public ones tend to evade taxes in ways that don’t sacrifice profitability (such as Apple earning all its money ‘overseas’) whereas private ones hide that they made the money at all. How big is that effect? It is probably real, but it seems unlikely either of these is common enough to be large relative to the effect size. The tax dodges continue to exist because they are small, and the tax evasion persists because it is plausible.
Hypothesis 7: Profit Non-Maximization
Perhaps some private firms do not actually try to maximize profits? If the employees largely own or run the company, they might return profits in the form of high wages (even if that’s tax-disadvantaged). The owners might have goodwill towards their workers or community or customers, and choose not to maximize. Certainly they would be less likely to aggressively fire people, if they didn’t need to. They might even hire people they don’t actually need, especially family members, driving down profits and up employee counts (and sometimes, this will be tax evasion too, see hypothesis six). They might simply ‘have enough’ and prefer to keep things going as they are, without having shareholder pressure to respond to. This is the story that being private is not always a good thing for the company. Private companies do often get lazy, and they also put a lot of value in the experience of the owners: They will often do things a certain way because that is what the people enjoy doing, and that’s a valid choice.
Profit non-maximization seems like a candidate for a substantial effect.
Is there still a puzzle?
Certainly we don’t know what share goes to what effect, but overall my instincts say no, that taken together these explanations should cover the observations we are trying to explain.
Private Firm vs. Public Firm Earnings
Robin Hanson asks:
That is a very large discrepancy, and neither the article nor its comments make a serious attempt to explain this very large difference. Here I will brainstorm a few explanations to see which ones make sense.
In his post, Robin presents strong evidence that suggests public firm managers lack the incentive to make long-term investments. An example given is:
This is likely to be an important piece of the puzzle, and should be kept in mind.
Hypothesis 1: Selection, Entry and Exit
Any private firm of sufficient size can choose to go public. When do such firms choose to do so? The owners would do so when they prefer the price they can get on the public markets to the profits they can earn keeping the company private. Similarly, any public firm can be taken private, given sufficient funds and the willingness to pay a premium over the share price. Again, you would take a firm private when you feel you can create value by doing so. Many have suggested that a lot of what private equity does is to default on implicit contracts and understandings, but whether that is true or not firms should still be taken private when they are cheap and opportunities other than such defaults tend to be high, although highly variable profit from defaults could add variance and thus decrease this correlation.
Public firm value greatly increases as current profits increase, and decreases as current profit decreases, out of proportion to the amounts involved. A lot of this effect is the signaling effect, as failing to meet earnings goals that everyone will punish you for not meeting is a very bad sign that you were unable to meet them rather than strategically choosing not to (I hope to expand on how toxic that type of logic is in another post, and explore possible ways to escape or contain it). It has also been observed that in the past, buying “cheap” stocks and selling “expensive” stocks, across a variety of fundamental metrics, has been a profitable long term strategy in the American stock market.
Thus, relatively unprofitable firms, and firms with declining profits, are good choices to take private even before considering that they are likely to offer better opportunities for turnaround and improvement via investment and strategic change, which seems also true. Similarly, private firms that can expect to report strong short term profits are good candidates to take public because the markets will reward those profits disproportionately with a higher stock price.
It has been pointed out, as was noted in the comments of Robin’s post, that investors are capable of understanding when a firm is investing in the future, if the firm is engaging in a well-publicized and company-wide strategy for doing so, but such firms still face the same incentive problems on the margin: surprisingly good or bad earnings have a disproportionate stock price effect, due to investor impatience and/or the signaling implications, and the investment effects are hidden. The market seems to be far more understanding of this type of action when it comes in the form of growth rather than investment in other ways. A company that is growing its market share seems to get a lot more slack on profits than a company that is investing in fixing its machines to improve its long term outlook, partly because it’s a much harder signal to fake.
Right now, this leads to a class of technologically-based firms that are judged on their market share and potential future profits rather than current profits, but such firms tend to have very few employees. In addition, the successful firms of this type tend to be like Google and Apple, and have huge profits from small numbers of employees, while being far too big to be private.
Public firms are larger!
Large firms tend to pay better, on average, than small firms, and large firms are more likely to be public. If you’re paying your employees more, each employee is (on average) likely to be producing more profits. Small firms tend to be private, especially very small firms, and very small firms often face fierce or even close to perfect competition (or worse, such as with restaurants).
Small firms that could be profitable often have the choice to reinvest most, all or far more than all those profits back into the business; most start-ups function this way. While they are private, they make little or no profits. When they turn the corner and are profitable, they go public. If they didn’t have good investment opportunities to seek growth, they were likely to be not that profitable, and often labors of love.
It seems likely that we have a large selection effect via entry, exit and choice of corporate plans.
Hypothesis 3: Overvaluing of Margins
I believe there are a large number of companies in which margins are effectively a sacred value. I believe such companies are more likely to be public. Hasbro is a good example; at least at one point, any product that didn’t have a 15% margin was automatically old, busted and shut down. Departments and managers were judged on the basis of profit margins in addition to quantity of profit. Some firms sell off their ‘unprofitable’ divisions to make it look like they’re more profitable, even if often those divisions were profitable. Very large firms have at least one good incentive to work this way, in that there are efficiency costs to being too big or lacking focus, or not having the right customer-facing message, so divisions and product lines could be profitable and still worth selling even at a very low price.
Low margin activities aren’t ‘sexy’ either, and are viewed by markets with suspicion. They don’t look like a good business to be in. This makes public firms shy away from them, since they won’t help the stock price in addition to making mangers look inefficient. This also would be another way that public firms are encouraged to take profits now rather than seek investment, which would drive up current profits for public firms relative to their number of employees.
Concerns about margins might be a substantial effect, but they also might not be. I don’t know enough to say.
Hypothesis 4: Growing Firm Value
This is Robin’s first hypothesis and sees quite reasonable. A private firm can focus on long term value. Wizards of the Coast under private ownership can (and did) choose not to flood the market with cards in order to lay the foundation for a game that lasts for decades rather than milk the fad for what it’s worth back in its first two or three years, a choice that it would be unable to make now that it is owned by Hasbro. Growth and profits are both respected by Wall Street, because both can be objectively observed and their trends projected. If you’re investing in growth as a public company, you can make that work for you. But if you’re investing in sustainability of any kind, or anything else hard to observe, that’s different. It’s very easy to cheat on these effects to look good.
If a firm needs to invest large amounts of money in the future, and thus for a time be far less profitable than it could be, it would likely either go private in order to do so, or fail to do so and look profitable while staying public until it failed to achieve what it could have later achieved through investment. This is a combination of the entry and exit effect, and the growing of firm value.
One problem with this theory is that money is very cheap and has been very cheap for years, so if private firms had reliable huge investment opportunities, then we would see them taking large loans in order to pursue those opportunities. Why should ‘low profits’ be a typical optimization point when the interest rate is basically zero? This implies that the investment opportunities are not so huge, and thus should not be able to eat up the majority of profits either, limiting the effect size.
A possible explanation for that is to consider that a lot of growing firm value is likely to actually be about sustaining firm value. Building and keeping a good foundation is often the best investment you can make, especially in a stable firm like a store that has no reason to expand or become a chain. You want to not charge a premium that would anger your customers, even if they’d have to pay, but it would be pointless to sell at a loss. You would likely even make investments around the area to build a relationship with your neighborhood, which would eat into profits. You want to make sure all your machines are in good working order and replace or upgrade them when it would save you money, but you only need so many of them, and so on. This limits the bleeding.
The counterargument, of course, is that if private firms can make profitable investments that public firms can’t, then long term that should make them more profitable per employee rather than less, unless those investments come in the form of growth, and growth is considered respectable by Wall Street.
Robin’s post sites that private firms invest 10% of assets each year, versus 4% for public firms. A lot of selection effects are doubtless part of that discrepancy, and so is firm value. Private firms are not valued as highly, so they aren’t really investing 150% more. I know one private business that was sold for only $50,000, despite having multiple employees; them investing 10% of assets would have been very low investment, rather than a large investment.
My guess is that reinvestment matters, but is smaller than the selection effects.
Hypothesis 5: Regulatory Capture and Regulation in General
Private and public companies can both seek regulatory capture. It is easier for large firms to do this than small firms, and firms that succeed will usually get large and profitable, perhaps then going public. It would appear at first glance that investing in regulatory capture is a long term investment and thus hard for public companies to work at, and there’s likely some degree of that, but the size effects and selection effects are probably larger. A lot of the biggest firms are effectively collecting rents they got via regulatory capture. This disincentivizes them to make other investments, and encourages them instead to milk things for all they are worth since they don’t have to compete.
In addition, lobbying and regulatory capture are dirt cheap. Buying political influence is an amazingly profitable investment, and large firms have proven able to recognize this and spend money here even if the payoff is a little bit down the road. In addition, if you get a law passed, that’s hard to fake, so the value captured can be reflected in the stock price right away, and might even be encouraged by markets rather than discouraged. When Disney wins a copyright extension, its managers are rewarded very well, thank you.
Regulations usually favor the large firm over the small firm, as they add many fixed costs and impose costs on market entry, and make it harder for superior but less known products to win out.
A final note is that congressmen can do insider trading, and often do, so having your shares available for purchase provides a nice incentive opportunity that private firms lack.
I would guess that regulatory capture contributes to this effect.
Hypothesis 6: Tax Law and Tax Evasion
Tax law was suggested by Robin, and it definitely happens that firms go down this road. There are businesses that exist as tax write-offs, or which choose relatively unprofitable paths due to tax advantages. This could be considered a special case of regulatory capture that is more available to private firms, but that drives paper profits down rather than up. Tax evasion is of course available to private firms in ways it isn’t available to public ones, and public ones tend to evade taxes in ways that don’t sacrifice profitability (such as Apple earning all its money ‘overseas’) whereas private ones hide that they made the money at all. How big is that effect? It is probably real, but it seems unlikely either of these is common enough to be large relative to the effect size. The tax dodges continue to exist because they are small, and the tax evasion persists because it is plausible.
Hypothesis 7: Profit Non-Maximization
Perhaps some private firms do not actually try to maximize profits? If the employees largely own or run the company, they might return profits in the form of high wages (even if that’s tax-disadvantaged). The owners might have goodwill towards their workers or community or customers, and choose not to maximize. Certainly they would be less likely to aggressively fire people, if they didn’t need to. They might even hire people they don’t actually need, especially family members, driving down profits and up employee counts (and sometimes, this will be tax evasion too, see hypothesis six). They might simply ‘have enough’ and prefer to keep things going as they are, without having shareholder pressure to respond to. This is the story that being private is not always a good thing for the company. Private companies do often get lazy, and they also put a lot of value in the experience of the owners: They will often do things a certain way because that is what the people enjoy doing, and that’s a valid choice.
Profit non-maximization seems like a candidate for a substantial effect.
Is there still a puzzle?
Certainly we don’t know what share goes to what effect, but overall my instincts say no, that taken together these explanations should cover the observations we are trying to explain.