Nominal Profits

Nominal Profits are the profits a company reports on its income statement in raw, unadjusted currency figures. Think of it as the “sticker price” of a company's earnings. If a company reports a profit of €1 million, that €1 million is its nominal profit. It’s the number everyone sees, the headline figure celebrated in press releases and news reports. While simple and straightforward, this figure tells only part of the story. It completely ignores the silent thief of wealth: inflation. Nominal profits don't account for the change in purchasing power over time. A million dollars today doesn't buy what a million dollars bought last year. For investors, especially those with a long-term, value-oriented mindset, understanding this distinction is crucial. Relying solely on nominal profits can create a dangerous illusion of success, making a company look like it’s thriving when, in reality, its true economic engine might be sputtering.

Imagine you run a small coffee shop. You sell a cup of coffee for $3.00, and your all-in costs (beans, milk, cup, rent) are $2.00, leaving you with a $1.00 nominal profit per cup. The next year, due to widespread inflation, your costs rise to $2.50. To compensate, you raise your price to $3.50. Your nominal profit is still $1.00 per cup. On paper, your profitability appears unchanged. But is it really? That $1.00 profit you earned this year buys less than the $1.00 you earned last year. It buys less new equipment, less advertising, and provides you with less personal purchasing power. Your “profit” has shrunk in real terms. This is the trap of nominal profits; they can mask a decline in a business's actual, wealth-creating ability. They measure the number of dollars you get, not what those dollars are worth.

To see the true picture, savvy investors focus on real profits.

Real profits are nominal profits adjusted for the effects of inflation. They reveal how much a company's purchasing power has actually increased over a period. It's the answer to the all-important question: “After accounting for the general rise in prices, is this business truly creating more wealth?” If a company's nominal profits grow by 5%, but inflation during the same period is 6%, its real profits have actually decreased by 1%. The business is treading water at best, and more likely, it's slowly sinking.

While there isn't a single line item for “real profits” on financial statements, an investor can make a smart approximation. The core idea is to subtract the wealth-eroding effect of inflation from the reported profit.

• A quick check: Real Profit Growth ≈ Nominal Profit Growth - Inflation Rate.

For a deeper analysis, investors often follow the wisdom of Warren Buffett, who has long argued that a business's true earnings must be measured after accounting for the inflationary costs of replacing its assets. A business must generate enough earnings to offset the rising replacement cost of its inventory and capital expenditures (new machinery, buildings, etc.) just to stand still. Any profit above that level is a true economic gain for its owners.

For a value investor, the distinction between nominal and real profits is everything. Our goal is to buy wonderful businesses at fair prices that can generate sustainable, long-term value. Focusing on real profits is a cornerstone of this approach.

• Identifies True Economic Moats: A company that consistently generates strong real profits likely has a durable competitive advantage, or what we call an economic moat. This often manifests as pricing power—the ability to raise prices to offset rising costs without losing customers to competitors.
• Avoids “Running to Stand Still” Businesses: Companies in highly competitive, capital-intensive industries often struggle to pass on inflationary costs. Their nominal profits might look decent, but their real profits are often weak or even negative. These are the hamsters on a wheel.
• Improves Valuation: When you project a company's future earnings, are you using nominal or real figures? Understanding a company's ability to generate real profits leads to more conservative and realistic valuations, protecting you from overpaying for a business that only looks good on the surface.

Let's look at “Widget Co.” and its reported results:

• Year 1: Revenue $1,000,000; Profit $100,000 (10% nominal profit margin)
• Year 2: Revenue $1,100,000; Profit $104,000 (9.5% nominal profit margin)

At first glance, nominal profit grew by 4% (from $100,000 to $104,000). An okay result. But let's add one more crucial piece of information: the inflation rate in Year 2 was 6%. Now, let's analyze the real picture:

1. Nominal Profit Growth: +4%
2. Inflation Rate: +6%
3. Real Profit Growth (Approximate): 4% - 6% = -2%

In terms of what that profit can actually buy, Widget Co. is poorer than it was the year before. Its purchasing power has declined. A value investor would see this and immediately dig deeper. Why did costs rise faster than the company could raise its prices? Does it lack pricing power? This simple shift from a nominal to a real perspective changes the entire story, turning a seemingly acceptable result into a significant red flag.