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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.)


Apr. 5th, 2010 01:46 pm (UTC)
Hmmm... actually, I think your explanation backs up exactly what I was getting at.

Maybe I didn't explain it well. What I'm saying is that it doesn't seem like it makes any difference to the stockholders financially whether the profits are transferred in dividends, the stock is bought back, or the profits are reinvested in the company. In any of the three cases, they receive their share of the profits. It's just three different ways of them getting it.

Let's say there are 1 million shares and the company makes an unexpected profit of $1-million. As soon as they announce it, the price per share should go up by $1. So at that point it has already really been transferred to them. If they pay that $1-million out in dividends, then it drops back down by $1 to what it already was, but they get the cash. If they don't pay dividends but re-invest it in the company or buy shares back, then it stays at the increased amount and they don't have the liquid cash but they still have the value in their portfolio and can sell it, cashing in on it, at any time. Right?
Apr. 5th, 2010 07:08 pm (UTC)
Why would the effect on stock price be the same if they re-invest the money in their business? Wouldn't that depend on *how* they re-invest it?

To make the point perfectly clear, suppose they reinvest it in a burnt offering of dollar bills to appease to gods of business.
Apr. 5th, 2010 11:34 pm (UTC)
Maybe there are different ways of thinking about it, but here is the way I have been thinking about it... so let me know if there is anything wrong with this:

- when the company makes an unexpected profit of $1-million, the value of the company immediately increases by $1-million. If they pay it to the stockholders directly in dividends, then it decreases by $1-million. If instead they spend it on new equipment for the company, or new locations, or whatever... then yes, it depends on how they spend it what happens. If they purchase $1-million of value for the company with that $1-million, then nothing changes. But if they get ripped off or squander it, the value goes down. If on the other hand, they get an especially good deal then it goes up. But I think those are after-the-fact corrections, where they have lost or gained value unexpectedly after making the initial $10-million.

I guess the difference in the way we're looking at it is that I'm seeing the company as having added value immediately any time its net assets unexpectedly increase, even before they spend it on anything. And it seems like automatically, if the company has more value then the stockholders have more money since they own a piece of the company. Paying the stockholders just seems like a formality, although I suppose there may be reasons for doing it that way.

The only thing I'm feeling now that doesn't quite make sense with the way I'm looking at it, is the issue of buybacks. I guess if I'm right about how it works, then the instantaneous stock price shouldn't actually change at all when they buy back stock. If they had the money and could have used it for something constructive, but instead used it to pay back existing investors, then the price would drop a bit, but that's exactly counteracted by the opposite effect of the pie being split fewer ways, so overall it seems the price should remain the same. Hmmm. So am I just wrong on that? If so, where is my wrong assumption?


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