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value, profit, and debt

Yesterday I went for a walk, and I started thinking about the concept of "profit" and realized that there is still something about it that I can't quite put my finger on that I don't understand. And it also made me think about a lot of interesting related issues about value and debt. I think some of this may be stuff that economists still argue about, and form different schools of thought over, and have written whole books about, so maybe it is ok that I don't understand it. On the other hand, maybe it is just basic knowledge and someone who knew more could fill me in.

I think part of what got me thinking about this was that I have a Roth IRA that I started in 2000, which is mostly composed of "safe" index funds but had one "risky" small cap stock in it, TIVO. Since I've had barely enough income to survive for most of grad school, I haven't even been able to contribute anything to it since 2002, and I haven't bothered to buy or sell anything in my portfolio since then either. For most of the past decade, TIVO has hovered between $5/share and $8/share, although I bought it in 2000 as it was taking a nose dive all the way down from $30/share during the dotcom bubble. At the time, it was not clear that the downward movement of technology stocks was due to a bubble bursting, and its price had already cut in half from $30 down to $15 so I bought 120 shares of it at around $15 (unfortunately, being 10 years ago I did not keep good enough records and do not know for sure what the actual price was). By the end of 2001 I had pretty much realized that I was stuck with having lost 2/3rds of my investment, and it didn't look like it would recover any time soon. But I figured maybe in the long term TIVO still had a chance of being a great product and getting into every home, so eventually it might recover. So I held on to it, and year after year it did nothing but oscillate between $5 and $8 occasionally going a bit higher or lower but not much change. Suddenly, a few weeks ago, it shot up to $17/share with the expected release of TIVO Premiere. So I thought about it for a bit, and put in a few stop-market sells over the course of a few days, to lock in my profits, and it still didn't fall down or go up much, and then just decided to sell it all. So I ended up making a profit after all, although for a 10 year period the rate of return I got was not very impressive... the equivalent of a little over 1% per year (13% overall) which is not as good as I could have done if it had put it in a CD or something with a fixed rate of return. Then again, everything else in my portfolio has done better, so my overall rate of return on my Roth IRA for the decade looks decent.

I'm not sure if it was thinking about this or about all of the financial shuffling I've been doing lately with the debt I'm trying to pay off (spread across 4 separate accounts--between that and the 3 different bank accounts I have open, I have been doing an incredible amount of moving money around from one place to another within the past few months).

But anyway, what I started wondering was two related things... where does the idea of "value" originate from when applied to stocks, and is it right to say there is "value" in the "profit" that is made by for-profit endeavors? If there is value in the profit that's made by for-profit endeavors, then that would seem to imply that non-profit endeavors that are just "breaking even" lack that value. Although if they are accomplishing the same thing, then in what sense can the non-profits be missing value? I think another part of me thinking about this may have been spawned by arguments on sifter lately about public versus private schools, where public schools are essentially non-profit, and 80% of private schools are religious so they are mostly non-profit, but the other 20% of private schools are secular, for-profit, and have much higher tuitions.

Usually when you buy something, like a skateboard, you get some kind of utility out of it, it has some value to you. Maybe that value is just that you enjoy riding around on it, or maybe it is that it helps get you to school or work on time. Or you could be buying a service, like a haircut or a car wash, but the point is you still derive some kind of value from making the purchase. Then there is money, which is somewhat special in that it doesn't have any immediate value to the person holding it, except that they know they can trade it in for something that does. The value there comes from the expectation that other people will do things for you or give you things if you pass the money on to them. But then there's stocks. What value do you get when you buy a stock? Surely if people purchase them, they have some value to the purchaser, but what is it? Exploring that thought, it seems clear that nobody who purchases a stock expects to get any kind of value out of it like the value they would from a skateboard. At best, if you had enough of it, for some stocks it might give you some weak voting rights in decisions the company makes, but for most stock transactions even that is not true. You don't get anything of value except that you expect that at some later point, you may be able to sell it to somebody else for more than you bought it. So is it like a collector's item, like antiques or coins or baseball cards? Where people buy them, hold onto them for a while, and know they can sell them for more later? Sort of, but that also seems different. At least with the collector's items, they have some sentimental value to somebody, somewhere. Most of the people collecting them may just be doing it to make a profit, but the fact that people are willing to pay more for them seems tied to the value at least some people place on owning them. Is there anyone that actually gets that kind of value from owning a stock, or does all of the value literally come from the expectation that it will have more value in the future? And if the value today comes from the expectation that the value tomorrow will be greater, but the value tomorrow comes from the expectation that the value the day after tomorrow will be even greater, then where does this process end and isn't there some kind of "origin" for the value rather than just an infinite nest of expectations? Is it really turtles all the way down, or is there some place we can trace this perceived value as coming from?

Looking at it from the other side, what is the difference between a for-profit and a non-profit? Every company has various expenses, and then they have income. A lot of the expenses are compensating the employees (including the management) for value they've added to the company through their labor and time. But if the income they receive from whatever product they are selling exceeds the value of the time and effort everyone put in to producing the product (plus whatever other expenses the company had, like rent, electricity, raw materials, etc.)... then we say justifiably that they "made a profit". For a non-profit, presumably the expenses match the income and they "break even". But for a for-profit, there are two questions relating to the profit: 1.) where did it come from?, and 2.) where does it go to after that? Let's put the first question off for now and look at the second question. They've already paid everyone including the management, so the profit must somehow go to the shareholders, which is where stocks come in.

Perhaps the difficulty in understanding "where the value comes from" in stocks stems from the language of buying and selling that we typically use to describe trading stocks. It seems to make a bit more sense if you view it instead as the investor giving the company a loan, and then getting paid back a return on their investment as compensation for the use of their money for a while. Then you can at least see where the value comes from that the investor offers the company. The investor could have used the money for other things, so they are giving up an "opportunity cost" to help the company be successful in their endeavor. As I was having all of these thoughts, it really sunk in that the phrase "it takes money to make money" is a very central and deep principle that drives a lot of this and explains a lot of this. The hidden value is in the fact that it takes money to make money, both from the point of view of the company and the point of view of the investor. Having a large pool of money gives you the ability to do large-scale projects that you couldn't otherwise accomplish. But there's a very spooky synergistic effect that if you put a whole bunch of money together and do something with it, then when you disassemble it back into the pieces afterwards and pay back everyone who put money in, you end up with more than you started with. Despite the fact that none of the people involved could have made the same thing happen with their money on their own.

So the phrase "it takes money to make money" explains where the investor's value comes from from the point of view of the company and why the "profit" can be viewed in some sense as another expense that was required to produce the product (because if there were no profits then there would be no investors to give them enough money for the endeavor in the first place). And it also explains why the investor is better off throwing their money into a pool with a lot of other investors instead of trying to do something with it themselves or just keep it in the bank. There is still the awkward question of how non-profits are able to do the things they do, although perhaps the answer there is just that a lot of them survive on donations. Initially, when I started thinking about this, I thought the difference was that for-profits require constant growth while non-profits expect to keep doing the same thing for a long time. And there is some truth in that, but I think there is also some truth in the insight that certain projects cannot be done unless there are either investors who can make a good return on their investments, or there are a lot of generous people willing to support a cause who will either donate money or put up money to use to get things started without requiring a return on their investment. Of course, if they do that, then they are losing out on whatever money they could have made doing something else with that money... but some causes are worthwhile enough that people are willing to do this.

So the phrase "it takes money to make money" I think explains where the hidden value comes from in stocks that seems so elusive initially. But that leads to more questions, about why this is considered value and what kind of value that is. And it also ties into the question of where the profits come from initially. At this point, I was near the end of my walk, and I think I came up with an answer, although the answer I came up with is kind of cynical and a bit disturbing and I'm not sure it's right (hopefully there is another way to look at it). The value ultimately seems to come from the fact that when there is a power imbalance between two groups of people in any game, the group in the position of advantage can exploit their position to extract value out of the group in the weaker position. So the extra value that comes out of the consumers after all of the workers who produced the product (including the management) are paid... that is drained out of the consumer group as a vampire would drain blood from its victim. The larger the financial backing behind the group in power, the easier it is to drain money from the groups lacking as much financial backing. Unfortunately, I think this may be the ultimate the origin of the phrase "it takes money to make money". The larger a coalition you form, the more power you have over those who form only smaller coalitions, and the more you can throw your weight around and bully others into submission. This is true not only for corporations, but also for labor unions or any groups. The larger the coalition the better your position. And if "it takes money to make money" is a theorem of capitalism, then a closely following corollary would seem to be "the rich get richer and the poor get poorer".

That said, I think there is one reason to be a little more optimistic about this--it's based on the analogy of a zero-sum game where whatever is gained by one group is lost by another. And in real life, that's not really the case. In reality, every person who is alive is continuously adding value to the world all the time, through their creativity, through their labor, and just through their being a person that other people like to be around. (Ok, there may be people like bin Laden or Hitler whose lives are a net subtraction from the total value in the world, but that's beside the point... the vast majority of people add value.) But even without it being a zero-sum game, I think the effect of leverage is very real and it is interesting that the idea of profit and growth is very tied into this idea of exploiting leverage. So my tenative conclusion is that profit and growth are ultimately due to exploitation, but the corollary of "the rich get richer and the poor get poorer" doesn't always follow because it's not a zero sum game. What happens instead is just that the rich get much richer, and the poor either stay the same or get only slightly richer, depending in large part on the political system in place.

Oh, debt! That's right, I put debt in the title and I almost forgot to say anything about it. Another thought that struck me as interesting after I got back from my walk was how one person's investment is another person's debt. I've heard a lot of people talking about the national debt lately. But what's called the "national debt" is actually a collection of treasury bonds (and other similar certificates) that investors buy when they want to invest in the future of the US. So every time the debt increases, it means that someone is supporting the US and placing a bet that we will continue to grow and do well as a nation in the future. In the same way that investors who buy a stock in a company are placing a bet that the company will do well in the future. Someone I was arguing with a month ago thought that the "debt" couldn't grow forever and it would soon lead to a collapse of the US empire unless we could find a way to "pay it off" and "get out of debt"... and that the higher it got the worse off we were. The first part is not true at all, and the last thing is true only if the debt/GDP ratio increases, not the debt itself. The existence of the debt itself is just an indication that people support the US, in the same way that stockholders support a company. So it's not something it would ever make sense to "pay off" or "get out of", although it does make sense to make sure our debt/income ratio doesn't get too high. Paying off the debt would be like all of the investors of a company dumping their stock, at which point the company would have to just shut down... it's not something that would ever happen unless the company was ready to die for other reasons. But the important point is that the price to earnings ratio should be healthy, so that you can continue to grow sustainably. Stocks are expected to go up, it just means that the "value" of the company has increased. (And in the case of the US, I think most of the increase in value over time is due to population growth, not the kind of phantom value discussed earlier.)


( 30 comments — Leave a comment )
Apr. 3rd, 2010 06:20 pm (UTC)
TIVO's stock jumps in recent years is due to courts upholding large IP judgements related to DVR technologies.
Apr. 4th, 2010 12:04 am (UTC)
You're right. I knew there were some court settlements, one being around the same time, but I had assumed since they publicly unveiled Premiere on March 2nd and the main surge happened on March 4th, they were related. But the court settlement happened on March 4th itself, and apparently most of the surge happened within an hour after the judge announced the decision.


I should have known that markets react far more quickly than a 2 day delay. At any rate, I feel a bit silly for selling it (since part of my reasoning was "this is just hype") but on the other hand I've kind of wanted to get rid of that stock for a long time and this was a nice excuse to drop it. It's just too volatile for a retirement portfolio.
Apr. 3rd, 2010 11:22 pm (UTC)
Well, for stock values we can regard the future profits of the company as an income stream (or, more generally, as a distribution over the space of possible future income streams), and argue that, given a certain time discount rate and risk aversion, a rational investor (in the sense that other preferences would be self-inconsistent) ought to be indifferent between that income stream and some (finite as long as the income stream's future growth rate is sufficiently small and interest rates do not asymptotically approach or reach zero) lump sum in the present. Thus, a sole proprietor owning a business can, in principle, given some set of expectations for the future, place a dollar value on it.

Now, suppose it's a publicly traded corporation. Internally, it still functions a lot like the sole proprietorship does: it hires people to do stuff, and sells some product, and hopefully makes a profit. Now, though, the management and the owners are in general different people, and the profit has to ultimately get to the owners somehow. For example, it can pay dividends to the stockholders. Then, being a 1/N stockholder gets you an income stream 1/N of what total ownership would get you, and so there's some 'rational' price for a 1/N share just as in the sole proprietor case as argued above.

Now, notice two things: first, the company doesn't have to spend all of its profits paying a dividend. It can also keep some in cash, or spend it expanding itself. Why should it do that? Because it has growth opportunities, or faces uncertainty about its future income stream and wants to hold liquid assets to buffer it, and that profit it just made is an easier source of capital for those purposes than issuing more shares or borrowing from a bank would be. A sole proprietorship would face the same choice on a logical level: if it makes a profit, whether to keep that in the business or transfer it to the owner personally, even though there isn't a *legal* distinction between the two.

In steady state, there wouldn't be any growth opportunities and there would be a certain finite amount of liquidity needed to buffer all expenses to a given confidence level for a given expected mean and variance of income and expense, so we can regard a 'mature' business as one that has reached this steady state and should try to return all profits to its owners, but an immature business would still have growth opportunities and should hold on to most of its profit. Of course, we can distinguish different points on a continuum between these extremes. Even old, mature businesses which have no growth opportunities in terms of introducing new products or improving their products or whatever would still have slow growth due to population increase, after all. I suppose the ultimate question is whether the expected return on re-investing a dollar at the margin into the business is higher than that on returning it to the stockholder so she can invest it elsewhere.

So, logically, the company faces a choice of how much of its profit to reinvest into itself and how much to return to its stockholders to use for other purposes, and this is independent of its form of ownership. The method of effecting that return varies a lot, though. For a sole proprietorship it's as simple as transferring from one bank account to another; for a corporation, it could pay dividends, but current tax laws make this a pretty inefficient method. Thus, most companies try to buy back their own shares instead, and if the efficient market hypothesis is true, then the market capitalization of the company should decrease by exactly the amount they spend doing so, and they've transferred that amount to the stockholders that just sold their shares.
Apr. 4th, 2010 12:21 am (UTC)
I had initially intended to mention dividends, just to say "let's not consider them for this" but it looks like I forgot to mention them at all.

Dividends was one of the first things that popped into my head as I was trying to think of what the value to an investor is. But most stocks don't pay dividends, and even for the ones that do that doesn't seem to be the primary reason why people buy them--it's still mostly because they expect the price to go up in the future.

But you add some really good points here that help explain things. I did not think about the issue of companies buying back stock to transfer value back to the investors. That's an interesting effect in and of itself.

An important point I was trying to make though is that even if the company never pays dividends (or buys back some of its stock) there is still some value being transferred to the stockholders every time the company makes a profit. That's because even if they use the profits to grow the company, that causes the stock price to go up. So I think what you say is right, that this is where the value comes from from the point of view of the investor... the investor knows that she will get a share of the company's profits one way or another. But it's interesting that that can happen in rather indirect ways.
Apr. 4th, 2010 01:41 am (UTC)
Yeah. Stock buybacks are the dominant means of returning value to investors in the US economy for tax reasons, so just thinking about dividends will make you underestimate the volume of that flow. I suspect that the idea that stock buybacks will, by increasing the price, effectively transfer to the on-paper value of the people holding the stock is true *in expectation value* in that if the stock prices were systematically wrong with respect to it there would be arbitrage opportunities, but that sort of analysis doesn't tell you anything about whether to expect the *variance* to be larger in one case or the other, and that a situation where most investors buy because they expect the price to go up rather than because they expect to receive a dividend income is more prone to speculative feedback loops.

As for value being transferred to investors whenever the company mnakes a profit, I don't think that's actually true. If you own 100 shares of XYZ that are worth $10 each at the current market price, you don't actually have $1,000, you have 100 shares of XYZ that you believe are worth $1,000 and which, as long as the present volume of trade in XYZ is much larger than 100 shares, you could sell for $1,000.

It definitely isn't true that the stock price goes up every time a company makes a profit; it happens all the time that companies release quarterly earnings statements saying that they made a profit, but less than had been expected by whatever analysts and widely-held beliefs were influencing the market price, and the stock goes down because of it. The information about the company's actual performance was influences the stock price relative to what expectation of its performance was already priced into it by the market, not in relation to some particular absolute scale.

Thus, I think the best way to describe this situation is something like this:

1.) XYZCorp announces a profit of $0.25/share, when everyone was expecting $0.30/share.

2.) Some investors decide to sell; the price goes down.

3.) The ones who buy those shares are, in effect, making a bet that the future of XYZCorp is brighter than those numbers make it look.

4.) If you owned some shares and just hold them, your investment is worth less on paper, but there hasn't actually been a real transfer; you just have lower expectations for the future and a lower estimate of how much what you own is 'really' worth. The real transfer has been between the people who just sold XYZ and the people who just bought it.
(no subject) - spoonless - Apr. 4th, 2010 04:47 pm (UTC) - Expand
(no subject) - puellavulnerata - Apr. 5th, 2010 04:16 am (UTC) - Expand
(no subject) - spoonless - Apr. 5th, 2010 01:46 pm (UTC) - Expand
(no subject) - puellavulnerata - Apr. 5th, 2010 07:08 pm (UTC) - Expand
(no subject) - spoonless - Apr. 5th, 2010 11:34 pm (UTC) - Expand
Apr. 4th, 2010 12:29 am (UTC)
Oh, regarding the idea of a "mature" company reaching a steady state situation where it no longer expects to grow...

Is that something any companies actually do?

(That's a serious question.)

My understanding was that in the business world, "grow or die" is the rule. Although I wonder how true that is really... surely it is more true in some sectors than others.
(no subject) - puellavulnerata - Apr. 4th, 2010 02:42 am (UTC) - Expand
(no subject) - spoonless - Apr. 4th, 2010 04:34 pm (UTC) - Expand
(no subject) - puellavulnerata - Apr. 4th, 2010 02:42 am (UTC) - Expand
Apr. 3rd, 2010 11:22 pm (UTC)

So, the 'value' of owning stock is the expectation that, through some means or other, the company will return a profit to its shareholders at some point in the future. Of course, expectations about that future vary quite a bit among investors, so it's also *speculative*. If you buy a share of XYZ at $10 and sell it at $20 to another investor rather than to XYZ itself in a buyback, then your $10 profit came from that investor minus what went to whoever you originally bought it from. If at some point in the future XYZ buys it from her at $30, then you, in effect, bet that it would go up to $20 and won, but not higher and lost. On the other hand, if the day after you sell a zombie plague breaks out in XYZ's main office (or any other unexpected disaster) and the person who bought it from you is stuck with a worthless share, then in effect you won your bet.

Whatever XYZ does that makes it a profit is presumably actually creating value directly, but in one sense that sort of speculation is zero sum, and if the 'noise' of speculation overwhelms the 'signal' of the company actually returning profit to its investors, you end up with distortions. I think a good conceptual model is that investment markets are a sort of non-linear amplifier, where the input signal is the actual peformance of the companies being traded and well-considered, independently formed expectations of their future performance, but there's also a lot of feedback in the form of 'herd behavior' by investors copying strategies that look successful for others - i.e., buying a stock because it's been going up in the past rather than because you have a good reason to believe it's undervalued by the market. Like an audio amplifier, it can have a sort of crossover point where on one side the signal is dominant, and on the other feedback takes over and the output is determined by internal properties of the amplifier itself rather than by the input. The equivalent in financial markets is a speculative bubble.
Apr. 4th, 2010 10:08 am (UTC)
Long post! Let me start simple and we can work from there:
Humanity is interested in a happy* existence. Objects, actions, and ideas have value (directly) if they keep us alive or keep us happy, and have value (indirectly) if they improve the value of other things (such as improving their efficiency). Currency is a medium for value-exchange. Investment creates net value because concentrating resources generally leads to higher efficiency. It is win/win for the investor and the investee(?).

*happy being a loose term for "without hardship, emotionally/mentally fulfilled, etc"

And in the case of the US, I think most of the increase in value over time is due to population growth

Nope. If so, then we would expect real GPD per capita to be roughly constant, which has not been true. Since 1910, GDP per cap has risen from ~$6k to ~$40k (both in 2005 dollars). Meanwhile, population has only ~tripled, which is a smaller effect. Basically, you've forgotten to account for all of our manufacturing infrastructure and scientific advancement, which allow us to produce more for a given man-hour.

Apr. 4th, 2010 04:08 pm (UTC)

And in the case of the US, I think most of the increase in value over time is due to population growth

Nope. If so, then we would expect real GPD per capita to be roughly constant, which has not been true. Since 1910, GDP per cap has risen from ~$6k to ~$40k (both in 2005 dollars). Meanwhile, population has only ~tripled, which is a smaller effect. Basically, you've forgotten to account for all of our manufacturing infrastructure and scientific advancement, which allow us to produce more for a given man-hour.

Good point.

The point of my statement there was to say that the growth in US GDP is probably not due to exploitation, but due to more healthy positive things. So I was not in any way trying to say that it was *just* due to population growth. However, you add an important and interesting correction... that growth of technology and infrastructure was twice as important as population growth.

I vaguely remember thinking of adding "and growth of technology and other things" after that last statement as I wrote it seemed tangential to the rest of what I was saying.

At any rate, after thinking about this more yesterday I am thinking of other ways in which the profits derived from "it takes money to make money" could be due in part to things other than exploitation, although I haven't quite worked that one out. I may due a followup post.
Apr. 4th, 2010 02:27 pm (UTC)
Hrm... Long reflection, but it didn't seem especially insightful.

Do you understand how much federal debt has? Add in state debt? Average that for each man, woman and child?

Treasury bonds aren't value. They're fiat. Whose buying them?

And stocks - they have more to do with the sociological agenda of the corporate model than you seem to give credit.

Have you watched any of Adam Curtis's documentaries?
Apr. 4th, 2010 02:28 pm (UTC)
"how much federal debt the US has"

yay for MID's! :)
Apr. 4th, 2010 02:38 pm (UTC)
Hrmm... After further reflection, I'm not sure 'not very insightful' works. The reflection was replete with insight. It just fell within a frame that excluded other insights (which I find more valuable). For example, you mention that the profit comes through exploitation - and this is where more Marx and less Buffet would be ... Insightful. ;)
Apr. 4th, 2010 03:46 pm (UTC)

Do you understand how much federal debt has? Add in state debt? Average that for each man, woman and child?

Yeah, I spent a long time arguing this with people a few months ago on a mailing list. And in the end, it turns out that it's really not that much. I've worked out the numbers, based on http://www.usdebtclock.org/ and other sources, and it turns out, we could easily pay off the entire debt in 10 years if we *wanted* to. It would just require every American to take a 10% paycut for those 10 years. However, the real question is, why would we want to? Paying the debt off is not something that would be desirable for anyone (either us or for our investors) so it would make no sense to do or even consider. Again, it would be the equivalent of a company buying back all of its stock from its stockholders... not something any company would ever do.
(no subject) - ankh_f_n_khonsu - Apr. 4th, 2010 04:28 pm (UTC) - Expand
(no subject) - spoonless - Apr. 4th, 2010 11:35 pm (UTC) - Expand
(no subject) - ankh_f_n_khonsu - Apr. 5th, 2010 12:20 am (UTC) - Expand
(no subject) - spoonless - Apr. 5th, 2010 02:38 am (UTC) - Expand
(no subject) - ankh_f_n_khonsu - Apr. 5th, 2010 02:52 am (UTC) - Expand
(no subject) - spoonless - Apr. 5th, 2010 03:42 am (UTC) - Expand
(no subject) - spoonless - Apr. 4th, 2010 11:47 pm (UTC) - Expand
Apr. 17th, 2010 02:05 pm (UTC)
In case you haven't already, I thought you might like to meet solarbird: http://solarbird.livejournal.com/934731.html
Apr. 17th, 2010 03:25 pm (UTC)
Thanks, added.
( 30 comments — Leave a comment )


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