Wednesday, February 07, 2018

What Passes For Logic

Dean Baker tells us today that in the late 1990’s, “many new startups actually were financing investment by issuing stock,” and that, “This is generally rare, since the vast majority of investment is financed by retained earnings and borrowing on credit markets or from banks.”

The stock market, according to Investopedia, “provides companies with access to capital in exchange for giving investors a slice of ownership.”

So startups in the 1990’s were doing precisely what the stock market exists to do; they were selling part ownership in their companies to investors in order to obtain capital to build their companies into major operations. And Dean Baker tells us this is rare.

In the same article he tells us that, “In principle the stock market is the value of future corporate profits,” which actually has become accepted thought generally and is factually nuts, being completely contrary to what the stock market actually is, in which a share of stock is a “slice of ownership.”

That “principle” assumes that purchasing stock entitles you to be paid a share of corporate profits, but it does nothing of the sort. Other than for “Subchapter S” corporations, which most large corporations are not, it entitles you to receive a dividend, which is declared by the board of directors and may be greater than or less than the profits achieved by the corporation.

Dividends are usually less than corporate profits, as the corporation maintains some cash in the form of “retained earnings” against future operations and investment. If dividends were larger than profits, which is sometimes the case in order to (falsely) maintain stock value, the corporation has to borrow the money to pay them.

So at best, this definition should read, “In principle the stock market is the value of future corporate declared dividends,” and would still be bogus, since it misdefines what the stock market is, in which (to repeat) a share of stock is “a slice of ownership.”

Investopedia goes on to describe the “primary market” in which initial offerings of stock are sold to investors to raise capital, and the “secondary market” in which stocks are bought and sold between traders. It is in the latter that the prices of stocks rise and fall based on their perceived value.

The real value of a stock is determined by the corporation’s net worth, reflected by the bottom line on its financial balance sheet, divided by the number of shares outstanding. The perceived value is, quite simply, whatever someone is willing to pay for it, and is often totally irrational. Witness tulips going for thousands of dollars per bulb in the 1800’s and Amazon at $1,458 today.

To claim that perceived value as being “the value of future corporate profits” is sort of putting invisible new clothes on the emperor and hoping that no little kid comes along. You buy a stock based on what you think you can sell it for in the future. It’s called gambling, and investors do it with the same logic that visitors to Las Vegas use at the craps table.

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