Supernormal Profits

Supernormal Profits (also known as 'Economic Profit' or 'Abnormal Profit') represent the financial holy grail for a business. It's the profit a company earns that exceeds its Total cost, where 'total cost' cleverly includes not just the obvious cash expenses but also the often-overlooked Opportunity cost. Opportunity cost is the potential benefit an investor or entrepreneur misses out on by choosing one alternative over another—for example, the salary a business owner forgoes by not taking a job elsewhere. In essence, a company earning supernormal profits isn't just covering its bills and paying its owners a fair market return for their time and capital; it's generating true, excess wealth. This is distinct from a Normal profit, which is the bare minimum required to keep the lights on and convince the owners not to shut down and invest their money elsewhere. A normal profit is good; a supernormal profit is fantastic.

On the surface, profit seems simple. But in investing, there's the profit you see and the profit that truly matters. Understanding the difference is crucial. The number you typically read about in a company's financial report is its Accounting profit. This is the straightforward calculation taught in introductory business classes:

• Accounting Profit = Total Revenue - Explicit Costs

Explicit costs are all the tangible, out-of-pocket expenses: rent, employee salaries, raw materials, marketing budgets, etc. It’s the money that physically leaves the company's bank account. Supernormal profit, however, tells a much deeper story. It accounts for the hidden costs of doing business:

• Supernormal Profit = Total Revenue - (Explicit Costs + Implicit Costs)

Implicit costs are the opportunity costs. They don't involve a cash payment but represent the value of the next-best alternative. For a company, this is primarily the return shareholders could have earned by investing their capital in another venture of similar risk.

Imagine a talented baker, Alice, who opens her own small bakery.

1. In her first year, she earns $120,000 in revenue.
2. Her explicit costs for flour, sugar, rent, and one part-time employee total $70,000.
3. Her accounting profit is $120,000 - $70,000 = $50,000. On paper, she’s successful!

But let's dig deeper. Alice is a skilled pastry chef who could easily earn a $60,000 salary working at a luxury hotel. This is her implicit cost—the salary she's giving up to run her own shop.

1. Her economic profit is $120,000 (Revenue) - $70,000 (Explicit Costs) - $60,000 (Implicit Cost) = -$10,000.

From an economic standpoint, Alice is actually losing money. She would have been $10,000 better off financially by taking the hotel job. Despite having a positive accounting profit, her bakery is not yet generating supernormal profits. It's not even making a normal profit.

Supernormal profits don't just happen by accident, and they certainly don't last long in a highly competitive market. If a business is making outsized returns, rivals will quickly pile in, copy the idea, and drive prices down until the excess profit disappears. So, how do some companies manage it for years, or even decades? They build a fortress. In investing, this fortress is called an Economic moat, a term popularized by legendary investor Warren Buffett. This moat is constructed from powerful Barriers to entry that keep competitors at bay. These barriers can include:

• Intangible Assets: Strong brand names (think Apple or Coca-Cola), patents (pharmaceuticals), or regulatory licenses that are difficult for others to obtain.
• Switching Costs: When it is expensive or a major hassle for customers to switch to a competitor's product (e.g., changing your bank or your company's core software system).
• Network Effects: When a product or service becomes more valuable as more people use it (e.g., social media platforms like Meta or payment systems like Visa).
• Cost Advantages: When a company can produce goods or services at a much lower cost than rivals, often due to massive scale (e.g., Amazon's logistics or Walmart's purchasing power).

These moats are why companies in market structures like a Monopoly or an Oligopoly can sustain supernormal profits. In contrast, an industry with Perfect competition is a brutal battlefield where supernormal profits are a fleeting dream, quickly competed away.

For a value investor, a consistent track record of generating supernormal profits is a flashing neon sign that screams “high-quality business.” It's hard evidence of a durable competitive advantage—that coveted economic moat.

• A Sign of Dominance: It proves the company has something special that competitors can't easily replicate.
• Fuel for Growth: These excess profits can be reinvested into the business to strengthen the moat, develop new products, or expand into new markets, creating a powerful cycle of compounding growth.
• Shareholder Returns: They provide the cash flow to pay sustainable dividends or buy back shares, directly rewarding investors.

The goal of a value investor isn't just to find a cheap company, but to find a wonderful company at a fair price. Identifying businesses with the ability to generate and, more importantly, protect their supernormal profits is at the very heart of that philosophy. It's the difference between buying a simple business and investing in a true wealth-creation machine.