What good is short-selling? (Econ for poets)

If you follow the business press, you’ve probably seen the raucous unfolding story about Herbalife, a company whose share-price has tumbled then oscillated ever since Bill Ackman, the hedge-fund manager, took a short position in the stock a couple months ago. Ackman has alleged that Herbalife is actually a pyramid scheme — i.e., that its revenue primarily comes not from its sale of actual goods, but from its ‘multi-level marketing’ strategy in which its distributors recruit new individuals to sign up as distributors, and take a portion of that sign-up fee in return. That is, Ackman alleges that Herbalife distributors are only making money by taking one-off payments from new distributors, which is obviously not a sustainable business strategy over the long run (how will Herbalife’s distributors make money once all 7 billion people on earth have been recruited, if it can’t make money by actually selling its goods?). Ackman wants the authorities to investigate Herbalife’s business model. Others, like Carl Icahn, have come to Herbalife’s defense, saying that Ackman’s allegations are misplaced and, more, since these false allegations have unjustly driven the company’s stock-price downward, the company is now a very good buy.

This story will, no doubt (as is every story’s wont), continue to unfold. But I wanted to use this opportunity to explain and explore the basic theory of short-selling in financial markets. Short-sellers don’t have a good reputation with the companies they target for short-selling, or with members of the public who think that short-sellers hurt the companies they target or profit from others’ losses or hurt the market. But I want to argue that short-sellers play a very valuable role. This post will have four basic parts: (1) I will explain what short-sellers do, emphasizing that they do not directly ‘take capital away’ from companies, and therefore do not directly hurt them. (2) I’ll argue that we as a society do not want the stock market just to go up and up as high as possible, but, rather, we want it to be correctly priced. In part (3) I’ll combine points (1) & (2) to argue that short-sellers play a valuable role. And (4) I’ll caveat my roseate view, and acknowledge and address some criticisms of short-sellers.


(1) What is short-selling? The basics: Suppose you have a very good reason to think that a stock is underpriced — that, all things considered, it will return more than the market rate in the future. What should you do? Obviously, you should buy it, which amounts to placing a bet on the stock’s rise. Colloquially, we call this ‘taking a long position’ in the stock. Now suppose that, after a few years, other investors fall in love with the stock, and, now, you think it’s overpriced. What do you? Obviously, you sell. But what if you see a stock that is overpriced, but you don’t own the stock in the first place? What do you do? It would obviously make no sense to buy it in order to then sell it — that would just incur two fees from your broker. So what can you do? Is there any way that you can bet on the decline of a stock’s price if you don’t own the stock in the first place (or bet on its decline beyond just selling off all of your shares)?

As you’ve probably guessed…yes, you can short-sell or ‘short’ the stock. How do I do that? Technically, when I short a stock is that I borrow it from someone else for a contracted time and at a contracted price (colloquially, we call this ‘taking a short position’ in the stock). This allows me to profit from the stock’s decline over the period of the contract. Here’s how it works: Say that stock in QWERT is trading for $100 a share. I could pay somebody else $10 to ‘borrow’ their stock for 1 year — if they expect the stock to rise, stay flat, or even only fall a little bit, then this is a great deal from their perspective. Then, I could immediately sell the stock at the market rate of $100. Then, at the end of the year, if the price of QWERT’s stock has declined to, say, $70 a share, I could repurchase the stock at this new, lower price, before returning it to the party I borrowed it from. So I paid $10 to borrow it for the year, sold it for $100, and then bought it back for $70 — I made a cool $20 while effectively investing only $10 of my own money for the year. (Modern markets are sufficiently sophisticated that I don’t actually write up individual contracts to borrow every stock I short — I can do it with a click of a button. But this transaction is legally happening somewhere underneath my click.)

If I’ve belabored this explanation a bit, it’s because I want to make clear a couple of key points: First, a ‘short position’ (just like a ‘long position’) is simply a transaction in secondary financial markets between consenting adult investors that doesn’t directly impact the capital that the company itself can access. A short-sale is the flip-side to any long position in a stock — long investors are gambling that the stock is underpriced, while short investors are gambling that it’s overpriced. What does this mean? Well, first it means that the common financial metaphors that compare short-sellers to sharks and predators are misleading. Short-sellers aren’t hurting other investors without their consent — when you borrow a stock to short it, your counterparty knows exactly what you’re doing, and makes a deal with you anyways, because s/he disagrees with your assessment. And short-sellers don’t directly harm the businesses they target (N.B. I’ll caveat this later). A company gets the equity capital that it needs in order to grow and function from its Initial Public Offerings and other direct share offerings. But as soon as a company sells shares to the public, the money it received on the sale belongs to it. So increases and decreases in the price that those shares trade for in secondary financial markets (i.e., fluctuations in the stock price) have no direct effect on the company’s store of and access to capital. To repeat: The equity that gets traded in secondary financial markets is completely distinct from the equity that is on the company’s Balance Sheet.

So what is short selling? Here’s another way to define it: It’s a legal transaction in which I’m a nice guy who takes the opposite side of two trades, paying a fee to a guy who wants to loan out his share for a year, and selling to a gal who really wants to take a long position in the stock. If I’m lucky, I make a profit on the trades. If I’m not, he and she do. The company’s day-to-day operations are usually completely unaffected by my trade.


(2) What do we want the stock market to do? Some theory: When I was a wee lad, before I understood basic financial theory, I thought of the stock market — as represented by the S&P500 index charted on TV screens and newspaper front pages — as a sort of agentic and determined creature, struggling admirably and valiantly and against adversity to move uphill. The S&P 500 chart was, I thought, a measure of the economy as a whole, and the higher it climbed, the better the world was. And wee-me was not the only one to think this way. Indeed, there’s interesting research at the intersection of cognitive science and financial theory that shows how even sophisticated financial commentators imbue their descriptions of stock prices with normative and agentic metaphors — an increase in stock prices is described as “the market vaulted to new heights,” while a decrease is inevitably written up as “another slip in a faltering market.” The basic metaphor that this language embeds and subconsciously conveys to us is: “The market is a self-willed agent, and it is an excellent thing when it ‘rises,’ and a sad thing when it ‘falls.'”

But this is not actually a rational way to think about the stock market. We don’t necessarily want stock prices to ‘climb’ higher and higher. Rather, we just want stocks to be priced correctly. Why? Well, there’s one very obvious and practical reason, and another less-obvious but more fundamental reason. The obvious reason is that when asset valuations just climb and climb, that causes a bubble, and bubbles usually pop, and cause a lot of instability and hell when they do. Bubbles are bad on the way up and on the way down — on the way up, I look at my stock portfolio and think I’m wealthier than I truly am and spend way too much; on the way down, I get upset about how much wealth I’ve lost and become risk averse and don’t buy enough. But is ‘popping’ the only problem with over-high asset valuations? What if we had a magic-wizard policy that could stop bubbles from popping by banning short-selling, etc., to keep bubbles permanently inflated? Would super-high asset valuations be a good thing in this magical world? Even here, economists would say ‘no,’ because even in this magic world, over-high valuations lead to a ‘misallocation of resources.’

What does this mean? Let’s explore a very simple model. Suppose that I have $100 in savings, which I’m considering investing in the IPO of PetApps.com, a new startup website that sells Apps that help your furry friend keep tabs on what other pets in the neighborhood are up to. (Yes, I’m being derisive.) It’s a ‘roaring’ ‘bull’ market that everyone wants a piece of, driving up equity valuations ‘through the roof.’ I realize that the PetApps.com IPO is overpriced relative to its true, fundamental value, but the market has so much ‘momentum’ that I can cash out of my investment while it’s still moving upwards. Should I invest in PetApps.com? Well, the answer depends on who’s asking the question. From my own selfish perspective, I should — I can make a profit by buying and selling quickly during this frenzy. But from society’s perspective, this investment would be a bad thing. Why? Well, when we say that shares of PetApps.com are ‘overpriced,’ we’re saying that, for their cost, these shares will not earn good returns in the future. In other words, capital invested in PetApps.com will not generate as much value as it would elsewhere; more colloquially, the management of PetApp.com is too incompetent to handle all that money wisely. That means that we would all be better off I invested my cash in some company that was undervalued, or in municipal bonds, or even if I just spent it on a vacation now, which would generate income for airlines, etc.

To generalize this thought experiment: At any given time, we have a lot of good options for what we can do with our money. Given that, we don’t just want to just put more and more value into any particular asset, because that would detract from the money that we could use for the other goods. Rather, we want to price each good correctly; this is what economists mean by ‘allocating capital efficiently.’ We as a society don’t just want company shares to sell for high prices per se during their IPOs — we want them to sell for correct prices, providing the company with exactly as much capital as it can use efficiently.

What about the secondary market (i.e, the buying and selling of stocks that you and I can do through E-Trade after the IPO)? As we noted above, trading in the secondary market does not directly effect the capital available to a company. So does it matter to the real economy? I think so. One way to think of secondary markets is as one big ecosystem that supports the ‘primary’ equity markets of IPOs. That is, primary investors in IPOs only invest in the first place because they are counting on the fact that they’ll be able to cash out by selling their shares, whenever they want, into a liquid market. If they made a wise investment decision during the IPO, investing capital in a company that went on to use it to do something transformative (like Apple), they’ll cash out into rising secondary markets, and make a killing. If they invested unwisely, wasting society’s scarce resources on Pets.com, they’ll lose a lot in secondary markets. Trading in secondary markets thus rewards and punishes investors for making efficient and inefficient investment decisions. It’s the ecosystem that is essentially supporting the basic business of getting good investments into good companies.

Also, companies often sell new share issues, well after their IPOs. Those shares will be sold at a price that reflects the total ‘market capitalization’ of company, calculated as the share price times shares outstanding (i.e., if your total market cap is $100,000, on 100 initial shares, and you issue 100 new shares, your 200 shares should now all sell and trade for $500 a piece, since the total value of the company should remain more or less unchanged). And so the same basic principles apply: We want secondary markets to price shares correctly, not highly, in order to prevent destabilizing bubbles, and to properly reward and punish good and bad allocation of capital. A rising S&P 500 is thus only a good thing if the S&P 500 had formerly been undervalued; a declining S&P 500 is a good thing if it had been overvalued. This is why the normative and agentic metaphors that our financial commentators use for the ‘climbing’ and ‘slipping’ market are problematic and misleading.


(3) Does short-selling help the market do what we want it to do? An argument: So let”s put the pieces of the puzzle together. How do short-sellers help support the economy? Well, the most obvious and commonly cited way is that they help provide ‘liquidity.’ If you want to buy a stock in financial markets, you’ll need to buy it from a seller — often a short-seller. But the more fundamental good they provide is that they help correct over-valued stocks. Recall that a short-sale is only profitable if the stock price actually does end up dropping, as the short-seller predicts. Short-sellers, by entering the market and becoming sellers, increase the for-sale supply of a stock and decrease the demand for it, bidding its price down. Short-sellers also have an incentive to publicly reveal their short position, to persuade other investors to drive down its stock price. Thusly do short sellers correct the prices of stocks that they believe are overpriced. This provides the indirect good of supporting the efficient allocation of capital, as discussed above. And often it has more direct, tangible benefits. Short-sellers have historically been very good — often better than the official regulators — at sniffing out and exposing accounting fraud and large companies. The threat of drawing the attention of short-sellers can help scare management teams (whose compensation is typically tied to the stock price) into behaving, being honest and transparent with analysts, not paying out lots of company cash for ‘consulting’ from shell companies they themselves (the managers) own, etc., etc. Short-sellers may be the best and most effective regulators the market has.


(4) Can there be abusive, harmful short-selling? Some caveats: I’ll admit that my perspective here is generally pretty positive about the value short-sellers provide, and I hope I’ve persuaded my readers to share this general feeling. But I think there are special and marginal cases in which short-selling can be harmful. What are these? The first is, most obviously, when a short-seller is wrong and deceptive about his evaluation of a stock’s true value. Suppose Bill Ackman is completely deluded about Herbalife, and the business is truly sound. If this turns out to be the case, then the stock price will eventually rise again, and Ackman’s hedge fund will suffer greatly, punishing him for his false assessment, and Herbalife will be fine. But what if Bill Ackman, having realized that Herbalife was sound, quietly exited his short position, without telling anybody? He might profit from doing this, since Herbalife’s stock has already dropped a great deal just on his allegations. If this happened, Ackman would hypothetically profit from, essentially, tricking the markets; Herbalife would have wasted a lot of its valuable capital on its legal threats to Ackman, its PR campaign, etc.. The markets would have, in this special case, rewarded the wicked and punished the good. Could this happen? Theoretically, yes, but in practice it’s unlikely. If he did this, Ackman would ruin his reputation and credibility on Wall Street for the rest of his life, which would be very costly to him in the end — so it’s very improbable that he or any other investor of significance would. More, delusion and deception are native to the human condition, and hardly unique to short-sellers. And why should we say that erroneously shorting a stock is so much worse than erroneously boosting a stock?

In theory, as we’ve noted, a short-sale can only profit you if the company’s stock price actually does drop, as your short-sale predicts. So a short-sale does not reward you for just attacking fundamentally sound companies. Are there exceptions to this? One possibility is that there could, in some marginal cases, be powerful self-fulling prophecies. Again, as I’ve emphasized, trading equity and balance-sheet equity are distinct; so short-sellers don’t deprive companies of the capital they need to do business. But my understanding is that for some companies, lending terms and other obligations are tied to their shares’ trading prices.  E.g., a company might be required to pay a higher interest rate on debt if its shares fall below a certain price. Or a bank that has entered into lots of derivatives contracts might be required to post lots of extra collateral immediately if its share price falls; posting this collateral could, in turn, force the bank to sell off other assets in a fire-sale, which would hurt its core business, initiating a downward spiral. These sorts of effects can be particularly harmful in major economic or financial crises — and so sound regulation should guard against these sorts of systemic and spiraling risks.

But we also hear this concern voiced outside of crisis situations. Some people worry about more mundane ways in which this self-fulfilling prophecy can work its evil. I.e., there’s a fear that short-sellers put heavy pressure on management teams to pay too much attention to short-term stock prices, which could cause them to lose track of sound management for the long run. Is there truth in this idea? Honestly, I’m pretty skeptical. On the most basic theoretical level, the value of a share consists in a slice of all the future profits of a company — so placing ‘the long-term value’ of a company in opposition to ‘its short-term stock price’ is a false dichotomy. More practically, it seems that it would require heroic skill to take down a fundamentally sound business just by psyching out the management. I suspect that this ‘concern’ about ‘harmful short-term pressure’ from short-sellers is largely mongered by management teams who aren’t very good at what they do, and want some pre-fabbed catch-phrases to take to the press, so that the big bad mean short-sellers will leave their company alone!


(5) Things I didn’t just write: This post has not argued that everything in the financial sector,  and our public-policy approaches to it, is a-okay. It has not argued that equity-trading is necessarily the most morally worthy of professions (I will also not say it is particularly morally unworthy). It has not argued that there is no excess of high-frequency trading in the markets. It has not argued that it is no problem that so much intellectual talent in the U.S. is pulled into the financial sector as against, say, engineering or teaching. It has not argued against circuit-breakers to prevent the massive crashes that can come from panic psychology or algorithm-driven trading. It has argued that short-sellers provide a valuable service that is essential to a modern economy, and the language and metaphors we use to describe them are misleading.

–Matthew Shaffer

What’s so important and interesting about accounting

In January, I took a very short intensive introductory course to financial accounting. When I first signed up for it, I cringed to think what my old Nietzsche-thesis advisor would think of such a practical and putatively boring endeavor. But I actually – I really mean this and I’m not just writing this to impress some future employer – found it very intrinsically interesting. So this will just be a brief post in which I’ll expend what I learned, by telling you what’s so interesting and important about accounting. After that, I want to give a brief intro to some of the basic ideas and concepts of accounting, partly because I had been frustrated, when I first started the course, that they are not usually explained well to people who are not already familiar with the field.

So first, what is financial accounting? I would define it as the set of rules and concepts we use to prepare relatively simple financial statements that capture or represent important truths about a firm and convey them to outsiders—both what the firm is worth now and what it’s doing on an ongoing basis. This definition suggests both (1) why accounting is important and (2) why I think accounting is interesting.

First, financial accounting is very important because the information that firms convey to outsiders determines whether, how much, and on what terms those outsiders lend to or invest in those firms. We as a society have limited amounts of capital to invest and lend. So we have an interest in that capital being used very wisely. We want it to be lent to or invested in firms that will use it productively, doing innovative and transformative things, and not lent to or invested in, e.g., hopeless companies overseen by feckless managers who are desperate for another lifeline when, in fact, their business models are outdated. The world would be better off today if more capital had gone to Apple and less to Pets.com during the 1990s. We also want investors and creditors of firms – after they have invested or lent – to continue to have an accurate picture of what’s going on inside a firm, so that they can monitor and pressure managers to behave and do well. In this vein of thought, it’s really not an overstatement to say that modern capitalism—in which public companies, owned by outside shareholders, must compete in capital markets to access the capital they need to grow—depends on good accounting. (Lastly: we as a society also increasingly want information about things like, e.g., how a firm is effecting and harming the natural environment, so we can figure out how best to regulate and efficiently abate these costs—this will become a more significant part of accounting in the future.)

Second, accounting is interesting because capturing and representing the truth about a firm is an intellectually challenging and fraught endeavor. The fundamental truth about a firm is actually fairly chaotic—a million different things of varying importance are going on at once—and we need to figure out rules for distilling some simple but accurate summary from this chaos. Accounting is in this sense a philosophical enterprise. The world itself does not label things as ‘assets’ or ‘expenses’; rather, we humans decide which labels we apply to which things; and we set rules for doing so based off of imperfect intuitions and ideas that involve human social ideas like justice (i.e., we want accounting standards that will promote fair and beneficial outcomes for society as a whole via efficiency and transparency) and conservatism (i.e., we want standards that will prevent managers of firms from doing self-servingly optimistic reporting, because we think that people can be selfish). I think it’s also helpful to analogize accounting to statistics, which is also about distilling useful trends from the chaos of data. How tall are women compared to men? Obviously, the fundamental truth is that there are 3.5 billion+ men in the world, each of a different height; and 3.5 billion+ women, each of a different height. Chaos, in other words. But if we have a research project that hinges on the relationship between gender and height, we have to find some simple way to describe the general relationship between these two populations. Statistics provides us with a way to extract out of the real world some useful artifices: The heights of the “average man” and the “average woman” (neither of whom actually exist as real things in the real world), and the standard deviation of each population—four simple numbers that capture most of what we need to know.

That’s why there’s actually a surprising amount of contention in accounting. For example, in the U.S., publicly listed firms issue financial statements according to U.S. GAAP (Generally Accepted Accounting Principles); in the EU, most countries require their firms to use IFRS (International Financial Reporting Standards). The U.S. has been planning, for years, to ‘converge’ its accounting standards with the IFRS—but this convergence has been slowed and stopped at various points, due to ineliminable disagreements. If representing the truth about a company were a simple, scientific enterprise, this would not be the case. Both U.S. GAAP and IFRS are constantly updated to keep up with business and financial innovation. How do firms account for some new complicated financial transaction, when the underlying goods don’t have the words ‘asset’ or ‘expense’ or ‘liability’ branded on them? That’s up to the bodies that oversee GAAP and IFRS—and both bodies pay lots of very smart people very good money to debate these rules all year.

A more practical introduction to financial accounting:

In practice, financial accounting results in the production of four financial statements. These statements are produced by accountants within a firm, and checked (or ‘audited’) by independent accounts outside the firm, and then disclosed in companies’ official public filings, such as quarterly and annual reports. Under GAAP, these four financial statements are: (1) the Balance Sheet, (2) the Income Statement, (3) the Statement of Retained Earnings, and (4) the Statement of Cash Flows. The most important, in my view, are the Balance Sheet and the Income Statement; so I want to just describe the basic concepts of, and sources of confusion around, these two financial statements, and then describe the basic idea of the other two more briefly.

The Balance Sheet

The Balance Sheet is supposed to capture what a firm is worth at a single point in time. It reports the company’s Assets, its Liabilities, and its Shareholders’ Equity. The Balance Sheet is based around the “accounting equation,” which you may have come across: Assets = Liabilities + Shareholders’ Equity. To understand this, you first need to know that Shareholders’ Equity, in accounting, is not the equity that gets traded in stock markets. Rather, Shareholders’ Equity in accounting is an accounting contrivance that is sort of defined as Assets – Liabilities. This means that the accounting equation is a simple identity. I just wanted to clarify that up front, because it tripped me up for two whole days when I first started with accounting, and not every textbook conveys it explicitly. Now, I think the best way to make the accounting equation clear, from here, is to illustrate it with a stylized story:

Suppose you start your own company. At the beginning, you invest $10,000 of your own money. The $10,000 you invested immediately becomes an asset of the company—cash on hand that the company can use. And because you, the owner, have invested this money yourself, and not taken out any loans, that $10,000 in assets is your equity in the company—if you shut the company down tomorrow, you could take the whole $10,000. So when you first invest $10,000 in your own company, the company has $10,000 in assets (cash) and $10,000 in equity, with no liabilities. $10,000 = 0 + $10,000. Get it? Now, suppose your next move is to pay $10,000 up front to rent a storefront for two years. You might think this $10,000 payment is an expense, but on the Balance Sheet, we consider this ‘prepaid rent’ an asset, because you’ll be able to use that storefront over the next two years in ways that will help you earn money. (Prepaying for rent is, in this sense, conceptually similar to buying, say, an annuity—both will pay out income for a set period, so both are assets.) So what did we do to the Balance Sheet and accounting equation? We just changed $10,000 worth of the asset ‘cash’ into $10,000 worth of the asset ‘prepaid rent.’ So the accounting equation is still at $10,000 = 0 + $10,000; on the Balance Sheet, all we did was change the name of the asset. How do we know that the ‘prepaid rent’ is truly worth $10,000? We don’t. In fact, you might hope that you’ve gotten a great deal on this storefront, and it’s truly worth $12,000. But we can’t just let you report the value of an asset at what you think its true worth is—you’ll probably inflate the value of all of your assets if we do. So GAAP requires you to be conservative, and report the value of your assets at the cost of their purchase—and to hold onto the receipt so you can prove it.

Next, suppose that you now need to buy inventory to fill up your store with goods that you can sell. You don’t have any cash left, so you go to bank, get a $10,000 loan and then use that loan to buy $10,000 worth of inventory. What just happened to our accounting equation? Well, inventory is an asset, because you can sell it to generate income, and the loan is a liability, because you’re liable for paying it back to the bank. So now you have: assets of $10,000 in prepaid rent and $10,000 in inventory… a $10,000 liability… and $10,000 in equity. $20,000 = $10,000 + $10,000. The accounting equation is still in balance. Get it? Now, things will get slightly harder. Suppose that over the first year, you sell half of your inventory for $25,000. What do we report at the end of the year? Well, since you’ve sold half your inventory, what you have left is only worth $5,000; in addition, you’ve now used up half the value of your prepaid rent. So those two assets are now worth only $10,000 combined. Meanwhile, you’ve just earned $25,000 in cash—an asset. So your total assets are now worth $35,000. But you still owe the bank $10,000, a liability, so your equity in the total assets owned by your company is now $25,000. And it makes sense that your equity increased by $15,000 total over the course of the year, because you just earned $25,000 by expending $10,000.

So you can see how, here, the accounting equation Assets = Liabilities + Shareholders’ Equity, must always be true, simply because of how we’ve defined the terms. It’s an identity. When you purchase assets in the first place, that purchase must have been financed by either debt or equity; if you purchase a new asset using the income you generated (i.e., reinvesting earnings), then that income had technically flowed through equity (since owners are entitled to profits), and so, again, your assets increase by the same amount as your equity. Hopefully you can use your imagination to see how this identity will still hold up when, e.g., the owner sells her shares to the public in an IPO; or the company has negative income for a year (say, using up $5,000 of a rent expense and $5,000 of inventory, and only getting $8,000 in income–thereby reducing Shareholders’ Equity by $2,000).

I’ve skipped over pretty much all of the actual details about how you put together a Balance Sheet—how you ‘depreciate’ the value of an asset over time, etc. But I hope I’ve conveyed the conceptual gist. The Balance Sheet is supposed to capture the value of a firm at a point in time—what assets does the company control, what portion of the value of those assets is owed to creditors, and, hence, how much of that value do we say belongs to equity owners?

But as I hinted above, Balance Sheet ‘Equity’ is not actually equal to the equity we’re used to—the equity that trades on stock markets at prices graphed on CNBC. In fact, usually they’re radically different. And this fact is a key to understanding the virtues and the limitation of the Balance Sheet. Necessarily, the difference means that investors do not value a company in the same way that the balance sheet does. I.e., the ‘market value’ usually does not equal the ‘book value’; or, investors disagree with the Balance Sheet about what a company is worth. Why is this the case? What accounts for this difference? In my understanding, there are two basic components to the difference:

First, the ‘true’ market value of assets and liabilities is different from their accounting or ‘book’ values, and investors are interested in market values. For example, suppose your company bought an office building in Williamsburg, Brooklyn, for $4 million in 1993. You might be required to value this asset on your Balance Sheet at $2 million right now (the historical purchase price, minus 20 years of depreciation expenses); but because Williamsburg has gentrified and New York City in general has revived so much since 1993, chances are the actual market value of your building is well over $4 million. (Alternatively, if you bought a building in downtown Tokyo during the height of the Japanese real-estate bubble in 1988, chances are your balance sheet overstates the value of that asset—which is one reason Japanese banks keep holding onto old real-estate investments. Similarly, some U.S. banks have been trading at below their book values, suggesting that investors think they will have to recognize losses on many of the assets they purchased before the financial crisis.) So while we have good reason for accounting for assets at their historical cost—namely, stopping managers from over-optimistically over-representing the value of their assets—this requirement means that assets are not reported at their ‘true’ value.

Second, and more importantly, investors do not simply value a company according to how much they would get if the company were to liquidate today. Rather, equity investors are also interested in owning a slice of all of the company’s prospective future profits. And this capability hinges on things like (1) the reputation it’s gained with customers and (2) the margins in the particular market space it’s entering, to name just two—things that are not captured on the Balance Sheet. That is, investors are interested not just in a company’s assets right now, but in its ability to generate income and profits on an ongoing basis into the future. And this, dear readers (thanks for your patience!), brings us to the Income Statement.


The Income Statement

The income statement is the financial statement that’s supposed to represent how the company is doing on an ongoing basis—the proverbial ‘bottom line’ refers to the company’s ‘net income’ which is listed, literally, on the bottom line of the income statement. Because net income is calculated for an ongoing basis, the income statement covers a period of time (the last fiscal year, in the annual report), rather than a particular point in time—i.e., it represents a flow, rather than a stock. The basics of the income statement are actually quite straightforward: for a firm, as for you and me, ‘net income’ is just revenue minus the expenses incurred in earning that revenue. The Income Statement just lists all the firm’s revenues, all of its expenses (including things like taxes), and then subtracts, and reports net income on the bottom line. It’s basically that simple. But there are a couple of extra interesting things we need to understand in order to get the significance of the Income Statement:

First, the Income Statement is fundamentally linked up with the Balance Sheet. For example, in each year, when you earn a positive net income (‘earnings’), you either pay out that income to owners as dividends or reinvest those earnings in the company, thereby increasing Shareholders’ Equity on the Balance Sheet. If you suffer a loss in a year, then the loss (by definition) reduces your assets without reducing your liabilities; so the loss is reflected in a decrease in Shareholders’ Equity. This is all laid out explicitly in the Statement of Shareholders’ Equity (see below); but it’s important to understand conceptually how the ‘slice in time’ valuation/financial position of a company  in the Balance Sheet is constantly being ‘updated’ by its flow of profits and losses as reported by the Income Statement. I.e., profits and losses flow through the Income Statement onto the Balance Sheet.

Second, the major counterintuitive thing about the Income Statement is that income is reported on an ‘accrual basis’ rather than a ‘cash basis.’ That is, to calculate your net income for a year, you don’t just subtract the cash you’ve paid out from the cash you’ve received (this would be ‘cash basis’); rather, you calculate the revenues you’ve ‘earned’ and subtract the expenses you’ve ‘accrued’. Let’s illustrate using the example company we worked with above, in the section on the Balance Sheet: At the beginning of the first year, I had paid out $10,000 for ‘prepaid rent,’ right? But on the income statement, we don’t record a $10,000 expense in year 1; we only record a $5,000 rent expense at the end of the year, because this is the amount of the asset that I ‘used up’ in earning my revenues in that year. Similarly, since I only sold half of my inventory during year 1, I only record half the cost of purchasing the inventory as an ‘expense’ on my income statement—because this is all the inventory I’ve ‘used up’ in earning my revenues. Finally, if I were to sell some inventory to a customer ‘on account’ (they promise to pay me in three months), I’ve already ‘earned’ this revenue, and so that makes it into the income statement even before they actually pay up.

Why do we do it this way? Well, there are a couple of theoretical and practical reasons. The most abstract theoretical reason is that if I have, e.g., a promise from someone that (s)he will pay me in one month, this promise is technically a financial asset right now, in that I have already secured a good guarantee of a future cash flow. And so, theoretically, I’ve impacted my company’s financial position (Balance Sheet) the moment I’ve earned the promise to pay from somebody else, and not in the moment when (s)he actually hands over the cash. Since the whole conceptual idea of the Financial Statements is that the Income Statement ‘flows in’ to the Balance Sheet, the Income Statement should reflect that I have earned the asset ‘promise to pay $X,’ right away—it shouldn’t wait for the exchange of one asset (cash) for another (the promise).

The more down-to-earth theoretical reason is that the Income Statement is supposed to give a good picture of what you can expect a company’s typical yearly income to be. If I invest $1 million in a building that I can use to earn $200,000 a year for the next 10 years, it doesn’t make sense for me to report a $800,000 loss this year, and a $200,000 profit for the next 9 years. I’m doing the same basic business in each year, so it would be a better representation of my true yearly income to recognize the building-purchase as an investment, and therefore to ‘allocate the expense’ of it over the next 10 years—meaning that I recognize $200,000 revenues and $100,000 of expenses, for $100,000 net income, for each of the 10 years.

And another practical reason to do it this way is that it prevents certain kinds of opportunistic and deceptive ‘earnings management.’ Suppose that you’re a manager of a company. You’ve had a very good year, but you have reason to believe that things are about to turn sour. You might be tempted, if we used cash-basis accounting, to do some creative accounting: For example, you could purchase all of the inventory you’ll need for next year up front (right now); that way, you would increase your ‘expenses’ in this year, and reduce your ‘expenses’ in the next year, smoothing out your earnings over the two years. That way, next year, your investors might not catch on that, actually, your company is going downhill fast, and so you could exercise your stock options at a high price well into your company’s downfall. Good for you; bad for everyone else. See the problem? Accrual accounting—by forcing managers to ‘match’ expenses to the period in which revenues are earned—prevents some of this opportunistic timing of expenses.

So that’s the basic conceptual gist of the Income Statement. The actual implementation is tricky business. ‘Accrual-basis’ accounting has some big advantages, but the downside is that doing an income statement with ‘cash-basis’ accounting would be a lot easier to control—you could just look at people’s cash receipts. With ‘accrual-basis’ accounting, we need lots of complex and debatable rules about how to ‘allocate the expense’ of various investment-purchases over time. And we can’t just match these expenses to reality using tangible cash receipts. The rules that accountants consequently use can get complex, debatable, and subject to judgment and discretion. This is why accounting is a serious profession involving a serious professional exam, etc.


The Statement of Shareholders’ Equity

This is the simplest financial statement, and, in my view, one that doesn’t really convey much extra information, but is just needed to bridge a technical gap between the Income Statement and the Balance Sheet, by reporting dividends, retained earnings, and the company’s transactions with its own owners (new share issues and repurchases). Basically, the Statement of Shareholders’ Equity just explains any changes in the Shareholder Equity figure (as reported on the Balance Sheet) from one year to the next. That figure is effected in intuitive ways by the company’s net income, dividends, and share repurchases/issues. If a firm earns a positive net income, it can distribute those earnings to its shareholders as cash dividends (in which case the money is taken off the company’s balance sheet entirely, because the cash now belongs to whomever it was paid to—the company is a distinct ‘entity’); or it can retain and reinvest those earnings, which increases Shareholder Equity on the balance sheet accordingly. If a company suffers a loss in a year, this detracts from Shareholder Equity directly. So in most years the Statement of Shareholders’ Equity just reports earnings and dividends, subtracts the latter from the former, and adds the difference to the old Shareholder Equity number to get the new Shareholder Equity number. In years in which the company issues new shares, or repurchases outstanding shares, this also shows up on Statement of Shareholders’ Equity.


The Statement of Cash Flows

The final statement is the Statement of Cash Flows. What does it do? Well, if we want our financial statements to give a good picture of the truth about a company, this statement should hopefully plug any gaps of information that other financial statements left out. As the name suggests, the Statement of Cash Flows reports the flow of cash in and out of the company over the past year—how much cash did you have then?; how much do you have now?; what accounts for the difference?; where did it all go?; how much went to investments?; how much was paid out in operations? In theory, you can get all of the information that is presented on the Statement of Cash Flows from the other financial statements. But there are a couple of reasons why it is useful to have a separate Statement of Cash Flows that focuses just on this cash information:

First, if you’re doing business with another firm—lending to them, or servicing or selling to them on account—you’ll want to be paid in cash. And since the Balance Sheet and Income Statement are technically based around the inflow and outflow of assets—not just cash—they may not clearly present all of the information you need. For example, suppose you’re in a bank, and debating whether to lend to a hedge fund. The hedge fund might look great on the Income Statement (earned a 30% ROA last year) and great on the Balance Sheet (a debt-to-equity ratio of only 2-to-1). But if the hedge fund isn’t keeping much cash on hand—indeed is paying a lot of it out to post collateral—and many of its assets are illiquid investments in, e.g, Australian timber woods, the hedge fund could easily get into a situation where it just couldn’t summon the cash to make its interest payments to you. Or suppose you’re doing some contract work for a startup firm that earned a lot of income last year, but hasn’t been able to collect the cash from the other firms it serviced—you might worry that, since they can’t turn their ‘accounts receivable’ into cash, they won’t be able to pay you cash for your work. So there are a lot of situations in which outsiders want to know about the cash situation of a company specifically; but the Income Statement and Balance Sheet focus on assets in general, not cash specifically. So the Cash Flow Statement plugs the gap there.

Second, and finally, the Statement of Cash Flows is also useful for monitoring and guarding against a couple of kinds of misbehavior related to imperfections of the other financial statements. When we went over the Income Statement, I explained why the Income Statement reports revenues and expenses on an ‘accrual basis’; when we talked about the Balance Sheet, I explained why it reports asset and liability values at their ‘historical cost.’ The way I think about the design of the Cash Flow Statement is that it is a useful check on the kinds of mischief and abuse that can come from those requirements in those statements. For example, because you must record assets such as buildings at their historical cost minus their depreciation, the ‘book’ value of these assets can be very different from their ‘true’ or market value. This provides a very ripe opportunity for earnings manipulation. Suppose your company’s basic business model is falling apart, and every day you’re losing money on your actual core operations—in this year, you’ll lose $6 million on operations. Suppose also that you own that building in Williamsburg whose ‘book value’ is now $2 million, but whose real, market value is some $10 million. If you sell off that office building, you can report an $8 million ‘gain’ on the sale, which will make up for your $6 million loss on operations, giving you $2 million in positive net income. With this phony liquidation, you can make things look good this year, increasing your assets, and bringing home big net income, even though this business model is clearly not sustainable. But whereas your Balance Sheet and Income Statement will look fine if you use this strategy, your Cash Flow Statement will reveal what you’re doing. The reason is that Cash Flow statements are divided into three separate sections: cash flows from operations (at top); cash flows from investing activities; and cash flows from financing activities. By clearly decomposing cash flows into these three separate categories (as opposed to the aggregation in the income statement), the Cash Flow Statement helps outsiders better monitor the success of your actual day-to-day operating activities.


This post doesn’t even scratch the surface of the detailed processes through which accounting actually happens. I just hoped to convey the theoretical concepts and an outsider’s appreciation for (a) how the four financial statements work together to represent the truth about a firm and (b) how our economy as a whole depends on that. The big takeaways from this post, I hope, are (1) accounting is interesting, because it involves a lot of complex and philosophical questions about ‘what is the truth about a company’s value, and how do we capture and distill it in a few numbers?’; (2) accounting is important, because the rules we use to convey information about companies’ value will impact which companies we invest in and which management teams we reward with big bonuses, etc., and so it’s a foundational structure for our economy; and (3) learning some basic accounting is worthwhile, because if you really want to understand what’s going on inside a business, beyond borrowing a few lines from the business press, you need to be able to understand a company’s financials and what they reveal—and, more importantly, what they don’t.

Should Apple “Disgorge the Cash”?

Over at Moneybox, Matt Yglesias has a nice summary of and commentary on hedge-fund investor David Einhorn’s attempts to get Apple to raise its stock price by making a credible promise to pay out larger dividends to its shareholders — and Apple’s subsequent refusal.

Basically, as we all know, Apple is one of the most profitable and seemingly promising companies in the world. But its price-to-earnings ratio (i.e., the price of the company as a whole [every one of its shares summed] divided by its yearly earnings) is low — about 10, compared to about 17 for the market as a whole. That is, investors are valuing ownership of the company at only ten times its yearly income, while valuing most companies at around 17 times their yearly income. Why is this? Well, it could be that investors are pessimistic about Apple’s future, thinking that its current high profit margins and market shares will be unsustainable as, e.g., the smartphone and tablet markets continue to get more competitive and mature. But another component of this is probably that investors are frustrated with Apple management’s refusal to return much of its profits back to the company’s owners in dividends and share repurchases. That is, Apple may have a high value, but that value isn’t getting returned to investors fast enough, and so investors are discounting the company. Apple has, instead of returning its enormous profits to investors as dividends, accumulated massive stockpiles of cash. As Yglesias notes, “Apple’s cash on hand represents over a third of its market capitalization, giving them a high cash-to-stock value ratio.”

Why has Apple done this? The main reason we see cited is that the tech world can be pretty volatile and Apple has gone through some very tough times in the past — so the company is holding on to this cash as a “war chest” in case it gets threatened by aggressing companies in the future. The cash could come in handy if Apple needs to beat back some competitor by selling products at a loss. Or if in 5 years, say, interest rates rise and some new technological space opens up, the cash will come in handy if Apple wants to make a huge investment in the new technology, without incurring new interest expenses by borrowing from banks to finance the investment. So it’s understandable that Apple’s management would accumulate cash. But it’s also very frustrating to Apple’s shareholders whose shares would, if the company were trading at the market-average P/E ratio, increase by 70%. (Keep in mind also that, given Apple’s huge market capitalization, its investors probably include you and me, if we’re invested in any sort of fund that tracks the market.) And it’s equally frustrating to those of us who take seriously the moral idea that managers should serve as agents as shareholders, and should return cash that the company does not have immediate use for — rather than withholding it and saying to the markets, as it were, ‘we know better than you what to do with this extra cash.’

Enter the charismatic David Einhorn, the activist investor at the head of Greenlight Capital. His hedge fund owns .12% of Apple, amounting to some $530 million worth of shares (meaning there is $370 million in it for his fund if Apple can start trading at a normal P/E). He’s been going on TV shows, and to Apple itself, with an idea that, he claims, can allow Apple to hold on to its “war chest” in the short-term, while credibly committing (read: legally binding) the company to return cash to shareholders over the long term. Basically, Einhorn wants Apple to issue a large “preferred stock dividend.” Preferred stock is stock that gives the company a legal obligation to pay a certain pre-defined dividend in perpetuity, if the company pays any dividends at all (this is why preferred stock is sometimes conceptualized as a “hybrid” between equity and debt). As a “stock dividend,” these proposed new preferred shares would be issued to existing shareholders (i.e., a “50% preferred stock dividend” would mean that a shareholder who had 2 shares of Apple common stock would additionally be granted 1 share of the new preferred stock). So Einhorn’s idea is that, by doing this, Apple would preserve its cash “war chest” right now while giving each shareholder a legally enforceable commitment to a larger dividend on her preferred shares — this should immediately increase the value of Apple shares, by beating back the skeptics who fear that Apple will never pay out. In Einhorn’s terminology, this would “unlock value” for shareholders, while still allowing Apple to preserve its conservative investment strategy.

Right now, as I understand it, this is all in a sort of confusing legal limbo — Apple made some changes to its corporate charter that, Einhorn claims, were intended to thwart this plan, so Einhorn threatened to sue to stop it; Apple claimed that Einhorn misunderstood what they were doing, and is seriously considering ways to return value to shareholders. It will, no doubt, continue to unfold. But I want to step back and consider this from a broader perspective. What should we want Apple to do? What is the “socially optimal” path? Yglesias writes:

Beyond the investment strategy debate, there’s a great issue here as to whether the “disgorge the cash” mentality that Einhorn reflects is socially optimal. In many cases I would argue that no, it isn’t. Microsoft’s shareholders would probably be better off if, years ago, the company had simply decided to ride out Windows/Office for as long as possible and kick the profits back as dividends. But the social returns to Redmond’s decision to not go gentle into that good night have been large. Microsoft hasn’t made any money creating Bing, but it has done consumers all around the world a huge favor in keeping Google honest. And Google’s fear that Windows Mobile would somehow lock it out of the mobile search marketplace was the initial impetus for the Android project. Android, too, doesn’t necessarily look like a great dollars-and-cents investment for Google, but it’s been fantastic for the broader world. Back in the day, we got R&D divisions like Xerox PARC and Bell Labs out of a similar “waste” of shareholder value.

So from my view, the problem with Apple’s cash is the reverse of Einhorn’s. They’re not wasting it aggressively enough. The company’s fastidious approach means they’re not going to blow $40 billion on trying and possibly failing to bring an autonomous car to market. They’re not investing in the creation of original programming the way Netflix is. They’re not running near-zero profit margins like Amazon. They’re just making lots of money, perhaps because Tim Cook watched The Corporation or read an Introduction to Microeconomics textbook and got it into his head that maximizing profits is what companies do. Which is kind of sad. They’re obviously really smart people and I bet they could make some cool stuff—and even come up with some plausible-sounding reasons for doing it—if they would just relax a bit.

In other words, Yglesias is pointing out that companies that reject a “narrow” focus on shareholder value give themselves the freedom to take on risky, innovative, not-clearly-profitable projects that can benefit society as a whole — like Microsoft giving Google some competition or Google pioneering driverless cars. Apple could, ideally, hold on to its cash and make some incredible investments in some other futuristic technology — say, something that would allow driverless cars to communicate with each other, so that cities can perfectly optimize traffic flows, etc. Now, I take very seriously what Yglesias is saying here — my long-time readers know just how very excited I am about the prospects of integrated driverless cars, an enterprise which is uncertain to do much for Google’s shareholders, but will do a lot for the world. But I want to push back with a couple of arguments, and then open this for debate.

-First, it’s a false dichotomy to say that companies must either “invest in our shared future” or “keep a narrow focus on shareholder value.” Rather, when a company returns cash to its shareholders, it’s putting money in their hands and allowing them to decide what to do with it. They can — and often do — decide to invest that money in some new, alternative startup that will also do a lot for our shared future. Would it be cool if Apple was doing some side-projects to integrate driverless cars with urban grids? Yes. It’d also be cool if I could cash out of my investment in Apple at a higher price, and invest that extra money in some other, outside startup that was doing the same thing. So you can’t just argue that a company should hold onto cash because “investing in our shared future is good” — rather, you have to argue that the company is better at investing in our shared future than are the capital markets. And if you endorse this position, this means you’re privileging the expertise of a small management team over the distributed knowledge of the market as a whole. That’s not a ridiculous idea — but it is, at least, a debatable one.

-Second, I think it’s important to step back and consider not just this particular company but the ecosystem of capital markets as a whole. When Apple went public in 1980, it was able to raise a lot of cash from the public because its investors took seriously the idea that Apple would do its best to give them a good return on their investment. And that IPO, by providing cash to a company that would use it to advance technology that would benefit the world in so many ways, was a great thing for the world. But if many more companies go down Apple’s subsequent alleged path — of failing to do its best to maximize shareholder value — investors may start to discount the price they’ll pay for shares in new companies. That will mean that less capital will make it to promising upstart companies, which would be bad for the world in the aggregate. In other words, the socially-efficient allocation of investment to startup companies in IPOs depends on a business culture in which management teams take seriously their role as “agents” of their investors. So even if in this particular case, Apple could do more good for the world by holding onto its cash, it might contribute to pessimism among investors, in ways that raise the cost of capital for future companies, hurting society in the long run.


Quick note. The Business Babe, who is generally more practical-minded than I am, just peeked over my shoulder and argued as follows: “Basically, a company should start paying a dividend once its market has matured, when it knows what its cash flow will be like, and won’t need to hold onto cash for new or unpredictable R&D investments. But once its past that stage, a company can’t hold onto investors with promises for the future — it needs to give them a steady return on their investment right now. And tech right now is sort of like the adolescent that refuses to leave home — not moving on to the next stage. The tech boom is over, and tech companies no longer need reserves they used to. And so to continue to hold on to their cash reserves is to be denial of what has happened. Tech companies have to recognize that the tech boom of the ’90s is over. Tech is a mature industry, and tech companies need to start acting like mature companies.”


So those are just a couple things to consider. Should Apple disgorge its cash reserves? What do you think?

–Matt, blogging boldly from snowed-in Boston

What We Talk About When We Talk About Branding [guest post]

Introductory note: What follows is a guest post from a close confidante of your main correspondent.  I have recently been encouraged by this confidante to both (1) develop my own personal ‘brand’ as an economics blogger, and (2) to occasionally move away from long-winded theoretical expositions, and toward practical, real-world stuff involving actual firms and news items. In the interest of advancing both of those ends, she has submitted this guest post.


A company’s brand is its image in the public eye. Tied to and built through names, symbols, phrases, and campaigns, a brand influences consumer behavior and allows a firm to command a premium price or a higher market share. In fact, Tide has such an excellent brand and higher perceived value that it has become an alternative street currency in New York.

But, seriously: On its most basic level, a brand’s value can be thought of as the price premium a consumer is willing to pay for it. Other metrics such as brand awareness, customer retention, market share and customer satisfaction can also be used to estimate a brand’s value. But a brand’s value is inherently slippery to quantify as it can fluctuate greatly from botched ad campaigns or other PR disasters, such as product recalls and corporate scandals. Essentially, we know that brands are worth something, we just don’t know how to accurately quantify this worth. However, that doesn’t mean that there aren’t interesting ways we can view branding and the value of brands, especially when brands are put in extreme situations, such as on the auction block during liquidation, or when popular brands represent unpopular (or nonexistent) products.


It was a difficult year for the legendarily imperishable confection, Twinkie, as its parent company, Hostess, filed for bankruptcy in early 2012. After negotiations with workers’ unions failed, Hostess was forced into liquidation in November. Consumers panicked, clearing shelves and listing boxes of Twinkies on Ebay for (I kid you not) over $200,000.

But this isn’t the story of a failed company. Rather, the most fascinating part of this process has been the forthcoming sale of the Hostess brand names. Brands from the legendary Twinkie to Hostess Cupcakes and Ding-Dongs will be auctioned off to the highest bidder, with potential suitors ranging from Walmart to McKee Foods. Creditors anticipate the sale tipping over a billion dollars, twice the company’s projected worth before liquidation.

The nuts and bolts of Hostess, its trained labor force, management, factories, and specialty machinery, are worth far less than its brands. In other words, the design stamped on a Twinkie’s box is more valuable than the Twinkie itself, the idea of the product surpassing and rising above the product itself. Anyone can make an elongated tube of cake and stuff it with frosting, but only the Twinkie can capture the American heart (arteries included) and with it, the American wallet.


Let’s push the power of branding forward another step by looking backwards, at the licensing schemes of French fashion houses. As the demand for couture slowed in the mid-20th century, houses began to license their name to third parties to take advantage of lucrative royalty fees. Pierre Cardin infamously allowed his name to be placed on bidets.

Ironically, as licensing schemes proliferated, couture sales continued to fall. French fashion production drifted away from the largest clothing market, America, by continuing to craft inaccessible, exorbitantly priced pieces that arrived too slowly for the modern fashion season. In the very moment when their brand was in highest demand, their couture was universally ignored. French fashion became intertwined in a vicious cycle where their historic couture reputation gave them a valuable brand name, profits came from stamping this name of a variety of third-party products, and unpopular seasons of couture were supported by these royalties. No one wanted French fashion, but everyone wanted French labels.


And now, dear readers, let’s move from the gilded past to the vulgar present. Twinkie is a case where the brand makes a perfectly simple snack valuable and French couture is an instance where a brand proliferates regardless of the disdain for the product it purports to represent. But I would argue that the pinnacle of branding, the crème de la crème, is the luscious Kim Kardashian. She is the American mega-queen of three-hit reality television shows, a chain of fashion boutiques, numerous lines of clothing, and one fabulously profitable wedding (and divorce) to Kris Humphries. But whereas Lance Armstrong, beneath his tarnished brand, represents athleticism and resilience, and while Justin Bieber offers his earnest, teenage croon, Kardashian is ostentatiously talentless. In an interview with the Guardian, she noted, “When I hear people say [what are you famous for?], I want to say, what are you talking about? I have a hit TV show.”

Her logic is circuitous; her fame justifying her fame. Transforming her life into a brand, she represents nothing except desire, price premium, and superiority. When you consume Kardashian, there is no utility beneath the brand and therefore no substitute—no generic alternative is possible. She is pure brand, pure fame, a slick white line of our powered need.


This is why this and every blog like it needs a brand. Without one, your Econ Blogger is merely a mind to readers. Similar to his minimalist WordPress theme, his words and paragraphs stand naked and open for judgment. Without the direction, the cushioning, the gentle shaping that a brand lends, he is yellow-sponge cake that must, on every read, be evaluated by its own, spongy merits.

There are intellectual benefits to this, of course. You may feel more open to criticize his work because of your lack prior investment.  You may be more receptive to his writing, not having seen an unflattering picture of him that may have biased your engagement. But the harms of this type of semi-anonymous work are far greater. Loyalty is built through branding, market share is gained by positing yourself not just as the best, but as fundamentally different, intriguing, intimately compelling. Engaged readers lock in and comment when they feel personally involved. If he wants to be remembered, he (along with all other WordPress blogs) needs more pieces that involve a Self, and some selfie shots, too—selfies are key.


One last word of caution. The main correspondent on this blog has legendary, dazzling, world-renowned blond hair, which he, in his public appearances, combs and folds into a cavalier and winsome side-part. Some critics have complained that it is too handsome to be endured and threatens the morals of the youth. There is, therefore, the danger of brand eclipsing the product, which may be why mdsy10 is nervous about taking this direction.

Private Equity: The Basic Idea

Private equity is back in the news with Dell’s announcement that it has accepted a $24 billion deal to go private. Private equity is hard for a lot of people to understand, so I thought I’d write an “economics for poets” post on the subject. This will mostly be descriptive—I’ll just lay out the basic idea of how private equity works. But then I’ll explore some normative connotations—I’ll try to advance the argument that, despite the negative connotations the things and ideas involved in private equity have right now, there’s good reason to believe that private equity usually creates value for shareholders and society.

First, what is private equity? The term most directly refers to ‘equity’ in ‘private’ companies. We all know how you can go to E-Trade and buy shares in a publicly-traded company. ‘Equity’ is just another term for shares of ownership. A ‘share of ownership’ of a company is a financial asset, because if you own a company—even in part—you can exercise control over its assets and you are legally entitled to some of the income it generates. A ‘private’ company is a company whose shares are not publicly traded, so it is not listed on a public exchange. (The distinction between ‘public’ and ‘private’ companies bears no reference to the distinction between the ‘public’ and ‘private’ sectors.)

Thus, ‘private equity’ just refers to an ownership stake in a private company. In that sense, then, venture-capitalists and angel investors—who invest in young startup companies, before they’ve gone public—technically own private equity in the companies they’ve invested in. However, when the private equity industry makes the news, it usually centers on private equity firms. What do private-equity firms do? Mostly, they’re so-named because they’re involved in buying, selling, and managing the ownership of private firms, outside of the initial angel investment stage. Their highest-profile activity, however, is buying out publicly-traded companies and taking them private.

This is what is happening to Dell. Its board of directors, who are legally required to represent the interest of the company’s shareholders, agreed to sell ownership of the company to a consortium of private-equity firms and individual investors. Dell’s current shareholders will receive, in return for their shares, a 25% premium over the price their shares had traded at for the last month. Through today, you could buy and sell its shares on the NASDAQ. Once the deal goes through, Dell will be delisted from the NASDAQ, and we ordinary people will not be able to own and trade its shares, because it will be owned by that consortium.

Why do private equity buyouts of public companies happen? Well, let’s answer this question by thinking about the parties to such a deal and what each party is hoping to get out of it. On one end, you have the owners (shareholders) of the company, and the board of directors who they’ve appointed to represent their interests. On the other end, you have the private-equity investors who want to take the company private. In order for the private-equity investors to take the company private, the board of directors must consent. So, first, why would a board of directors consent to a buyout? Well, the board is supposed to respect its ‘fiduciary responsibility’ to pursue the shareholders’ interests—that is, maximize the value of their shares. So if a private-equity consortium is willing to pay a significant premium over the current market price of the company’s shares—and the board has no reason to believe that the shares in the company will increase in price any time soon—then selling off ownership of the company to the highest bidder is exactly what they should do to maximize shareholder value. So if a public company whose stock price shows few signs of rising receives a buyout offer from a private-equity firm, the board of directors of the public company ought to negotiate for a high premium by shopping around for the highest bidder—whoever will pay the most to its shareholders. If it gets a good offer, the board should agree to take it.

What about the other side of the deal? Why do private-equity investors and consortia pay premiums to buy out publicly traded companies? Well, clearly they’re hoping to make a profit. Specifically, private-equity investors that take public companies private are often hoping to profitably ‘exit’ from this investment by reselling the company to the public at a higher price in the future. But how can they think that they can make a profit on such a deal, sufficient to compensate them for all the risk and legal difficulties involved? I want to cue my readers in that this is actually a challenging and interesting question. After all, the price of a company’s stock on a public exchange represents investors’ best analysis of what that company is actually worth. If it were obvious that a company were worth much more than its current stock price, investors would bid it up to the correct price. If private-equity investors had a good reason to believe that a company’s stock was undervalued, and that the broader investment community was just too bone-headed to see the obvious, then those investors could simply accumulate large shares in those companies in the public markets and use that controlling share to make the management do a better job of communicating the company’s true value to investors. This would be much less costly than structuring a private buyout and paying a premium.

So, again, why would I pay a premium (plus all the legal expenses of structuring the deal) to take a company private? Necessarily, I would only do so if I believed that I could add value to the company by taking it private. If the market is currently valuing a company at $80 million, and I pay a premium of 25% (i.e., buy the company for $100 million), and then resell the company (either to the public, by relisting it on a public exchange, or to other private-equity investors) one year from now for $120 million, that’s a 20% return on investment in one year. That’s how I can make a profit despite paying a premium to buy out a public company. I shouldn’t bear the risk of a private-equity deal unless I have reason to believe I can increase the value of the company by a large amount (in the example I used I had to increase its value by 50% just to earn a 20% ROI), by taking it private.

But this raises another question: how can you add value to a company by taking it private? Or, to put this another way, what is it that a company’s status as a publicly-listed company prevents you from doing something that can add substantial value? I warn again that this is actually a theoretically challenging question. After all, self-interested shareholders of publicly-listed companies should want the company’s management to do anything and everything it can to maximize the company’s value. Theoretically, they shouldn’t stop anything that will increase the firm’s value.

So how does public ownership hold you back? There are a couple of ideas on this. First, shareholders in public markets can have an overly short-term focus and react emotionally to news that they misunderstand. As a result of this, managers of public companies feel under pressure to, e.g., put a lot of effort into ‘earnings management’ so that their quarterly reports will show smooth and steady increases in earnings, each and every quarter, even when this ‘management’ is not ideal for the long-term value of the company. To use a simplified example, suppose a firm wanted to sell off a lot of assets that it no longer had much use for. This would be a good decision for the firm’s long-term value. But suppose that, because of the way they’ve accounted for deterioration of these assets, the ‘fair value’ (the real market price) of these assets is below the ‘book value’ (the value contrived for accounting purposes). In this case, selling these assets would force the company to recognize a loss in its quarterly report, which would cause some investors to sell it off, hurting its stock price, which would upset stockholders and directors who would have some of their wealth wiped out. So shareholders might support and reappoint directors who prevent management from doing these things. Similarly, managers of public companies often feel that they can’t make risky moves, acquisitions, or re-brandings that would increase the firm’s value in the long term, because investors are too risk-averse. Additionally, because the board of directors has to sign off on a lot of management decisions, if different board members have very different (even if equally good) ideas for the future of the company, they can put a company in ‘gridlock,’ voting against each other, preventing the company from moving swiftly and authoritatively in one direction or another.

So, in sum, taking a company private can allow it to be managed in a way that is riskier, more authoritative, and less caught up in short-term appearances. This can increase its value. If private-equity investors can increase the value of a company that they’ve taken private, they can subsequently sell it at a profit.

Other, somewhat sketchier reasons to do a private-equity buyout have to do with what we call “regulatory arbitrage.” Publicly-listed companies face more stringent regulations and requirements on information they must disclose than do private companies. So if your plan to add value to a company involves doing something that you don’t want the public to find out about, you might take the company private for that reason… Finally, profits to publicly-traded companies face ‘double taxation’—i.e., they are taxed once as corporate income and then again when they are returned to shareholders as dividends. So, in theory at least, a private equity investor might stand to profit by taking a corporation private (as opposed to just accumulating its shares in public markets), even without a huge value-add proposition, if (s)he can get a big tax advantage from doing this.

But in general, private-equity deals are struck through the shared interest of the two parties: a private-equity consortium will only get together to finance a buyout of a publicly-traded company if it has a good reason to believe it can improve and add value to the company by taking it private; a board of directors should only agree to the deal if it will compensate shareholders with the best value they could reasonably expect to get on their shares. So the typical private-equity deal should be a win-win for a company’s shareholders and society as a whole.


What does this all mean? Well, first, there should be some apparent normative connotations to what I’ve written here so far. The very closing of a private-equity deal itself counts as evidence that value has been created for shareholders and that more value will be created for society as a whole (in the form of a company that has more value by virtue of its ability to do a better and more efficient job at satisfying our needs and wants). In general, a private-equity deal won’t get closed unless these two conditions are met; and the continued existence of the private-equity industry is evidence that those conditions do get met frequently enough. So I’d say we have good reasons to generally feel pretty positive about the private-equity industry.


So why does the private-equity industry have such a negative connotation? A couple things come up frequently.

-First, in general, I think people often imbue economic terminology with normative connotations, without thinking deeply about the underlying reality. My sense is that when people read that a company, having been taken private, is “spinning off” divisions or “selling off assets,” they have an image in their minds of an exhausted old man just giving up. But it’s wrong to anthropomorphize companies like this. In reality, becoming leaner by spinning off divisions and assets—selling them to another firm that can make use of it better than you can right now—can just be a really smart thing to do, and good for society as a whole. Indeed, the fact that another firm would be willing to pay you a good price for a division that you want to spin off  would stand as evidence that they can make better use of it than you can.

-Second, more specifically, during the 2012 presidential campaign, attention was drawn to how private-equity takeovers of firms often resulted in job losses and layoffs. I don’t want to lack sympathy for laid-off workers. But I’m not sure that this is a problem of private equity per se. After all, publicly-listed companies also lay off and abuse employees. More, in order for our economy as a whole to function well, some people need to lose their jobs sometimes. This is rough on those individuals. But in the long run, we all benefit from this process of “creative destruction,” where old industries become streamlined and more efficient, and their workers move into new industries that actually require their labor. In fact, private-equity, by improving the efficiency of a number of industries, also creates a lot of jobs, too—perhaps more, all things considered, than it destroys.

-Third, people point to potential kinds of abuse. For example, suppose a public company was holding a lot of cash. You might worry that a private-equity consortium could go in, take over the company, take it private, use that cash just to pay itself lots of dividends, load the firm up with even more debt, and then sell it off once again for a profit. In this story, the value of the company was destroyed while the private-equity consortium laughed all the way to the bank. But, if you think about it, this kind of manipulation actually couldn’t happen in a world with basic good corporate governance and disclosure. First, if a company is sitting on a lot of cash (1) that should be reflected in its stock price, since equity owners would be entitled to a share of it and (2) a good board of directors would have pressured management to employ that cash wisely anyways, either investing it where it could earn a good return, or returning it to shareholders directly in dividends and share repurchases. Second, if you’ve loaded a firm up with lots of debt just before selling it off, this information should be disclosed to prospective investors, who would subsequently not be willing to pay as much for the firm. So loading a firm up with debt to pay your private consortium lots of dividends will just hurt the resale value of the company—meaning you won’t profit overall. So if deals like this actually do happen, it’s a problem of deceit, and basic failures of regulation and corporate governance, not of private equity per se. And if we had transparency and good governance in place, these deals couldn’t be profitable to private-equity consortia unless value was actually created.


Do I seem way too rosy about private equity? I’ll raise one concern, then. If we want to look for a way in which private equity per se is problematic, we should look for ways in which a private-equity deal can be profitable for its dealers without adding value. Are there any such things?

As I see it, the main potential for abuse is the possibility of self-dealing by managers. Think of it this way. Suppose your company is trading at $50 million in public stock markets. Suppose you, as a manager, have insider information that suggests that in reality your company is worth $100 million. Now, as a manager, it is your fiduciary responsibility to help your shareholders. What you ought to do is publicly reveal the information that shows that your company is worth $100 million, and then watch the stock price rise. But you have another, corrupt, option. You could work with some other senior managers, and get funding from a bank to do a leveraged buyout yourself. You could buy the company for, say, $60 million (a 20% premium); then, when the time came to resell the company to the public, you could reveal your insider information, and sell it for $100 million. Your original shareholders get screwed out of $40 million worth of their shares, and you capture all of that profit, without creating any new, real value. So management-led private equity deals can be profitable for managers, but harmful to shareholders, because the management can profit from good timing and concealing information, rather than from adding value.

So private-equity deals led by a company’s management should be the most suspect deals. But again, even here, the problem goes deeper than private equity—such a manager would be violating his fundamental fiduciary responsibilities, and actively deceiving and withholding information for the public. That’s not just private equity’s problem.

Research dump, 2/4/2013:

This is just a summary of some cool economics research I’ve come across recently, with some brief notes about how each study relates to broader theoretical ideas:

-The Sarbanes-Oxley Act is often credited with improving corporate governance in the U.S. in the wake of the Enron and Worldcom accounting scandals. But two professors have done some statistical analysis that suggests that accounting manipulation—and investors’ susceptibility to this manipulation—sharply decreased before Sarbanes-Oxley went into effect, but after the salient scandals. That is, improvements in corporate governance seemed to come from market participants themselves becoming more attentive to potential fraud, after the Enron and WorldCom scandals, rather than from the new regulations themselves.  So in this case at least, the market beat regulators to the punch in enforcing reform and better practice. The interesting idea here relates to how most people, when they think of ‘regulation,’ think of the laws drawn up and enforced by governments—but economists think of ‘regulation’ happening within markets, too. People in the private sector, after all, don’t like getting defrauded, so they take their own measures against it and do their own monitoring.

-Economic incentives matter. Like, a lot. As in, even in life-and-death situations. People are more inclined to crash their own planes when others can be held liable for the cost of the damage to the plane. It’s popular to accuse economics of leaving out “the human factor,” and such. But there’s plenty of interesting research out there that, like this study, shows the astonishing ways in which money influences our behavior more than we like to believe.

-A number of recent papers have argued that our measure of inflation—the Consumer Price Index—has led us to be overly-pessimistic about how lower- and middle-income Americans have fared over the past several decades. Prices for low-income consumers have inflated more slowly than prices for American goods as a whole (in part thanks to super-efficient retailers like Wal Mart), and so aggregate measures of inflation overstate the cost-of-living for low-income people. So this paper argues that while ‘income poverty’ is not declining as fast as we would like, ‘consumption poverty’ has declined encouragingly over the past five decades. In general, measuring ‘inflation’ is incredibly tricky, not just because of the difficulties of measurement, but also for broader philosophical reasons—we essentially measure ‘inflation’ by comparing the sum price of two comparable baskets of goods in different time periods, but technological changes that mean that, e.g., every consumer’s basket of goods is a little bit better in subtle ways in year 2010 than it was in 1960, and so the idea of a ‘comparable basket’ is very debatable and fraught.  And so the measurement of inflation is just one of the many areas where economics is more art than science, and in which the ‘art’ has major implications for our understanding of what’s going on in the world right now.

-I posted several weeks ago some new research and theory that suggested that, contrary to classical economic theory, increases in the minimum wage did not increase unemployment. But now, other economists have fired back with some critiques of the research design of those studies, and their own evidence that minimum wage hikes do increase unemployment. I won’t take sides in this debate, but just say that it’s a reminder that teasing out statistical trends from the chaos of real-world data is really, really hard, and, again, sometimes more art than science.

-How do financial crises (i.e., in the financial sector) become economic recessions (i.e., for the rest of us)? The answer is not as simple as, I think, an economic novice would assume. I think a lot of ordinary people look at the S&P500 figures they see on CNBC as a straight measure of how the economy is doing, but that’s not strictly correct. For example, imagine that a superior extraterrestrial species were to inform us all that the earth would be destroyed in 10 years—the stock market would tank, because the “net present discounted” value of all shares would decline since they all only have 10 years left. But as long as we all kept buying goods and living our lives like we do for the next 9 years, the real economy should do just fine: if we continued buying all the same goods, then sellers would be selling all the same goods, so the real economy wouldn’t change much. So how exactly do financial crises spread into the real economy? What connects these two universes? One answer is the “wealth effect”—i.e., if the savings you have stored in financial assets have been devastated, you’re going to want to “repair your balance sheet” by saving more, to bring your wealth back up to what you had previously thought it was. This means you’re going to spend less now, which means that the people you normally buy from are going to have less income now. That’s a major mechanism through which financial crises spread into the real economy. The great housing economist Robert Shiller and two other economists have some new data on how “wealth effects” related to the housing sector have affected consumption throughout U.S. history. Housing prices appear to affect consumer spending even more strongly than stock prices, presumably partly because more of us are heavily invested in our housing than in the stock market. So this is both (1) a big part of the explanation of the economic doldrums of the past five years and (2) a more general reminder of how stable housing markets are important to the broader economy, and policies and financial ‘innovations’ that destabilize the housing market can be a big threat to all of us…

-A big debate in the econ-policy world right is, essentially, “Are the Luddites, this time around, actually right?” That is, since the industrial revolution, in every generation people have been worried that new technologies would replace labor, leading  to widespread unemployment and poverty. But so far, in every generation, the Luddites have been wrong, and we’ve found ways in which people can ‘complement’ those technologies, instead of being replaced by them, such that technological advances since the industrial revolution have led to a higher standard of living for everyone. But could this change in the future? Could this time really be different? One fear is that once Artificial Intelligence becomes sufficiently advanced that it can match an adult human brain, then, by definition, there will be nothing a robot can’t do to substitute for human labor, and so the Luddites will finally be right. In a new paper, Jeff Sachs and Laurence Kotlikoff present a scary stylized model, in which current, established generations of skilled employees use future artificial technologies to substitute for young, unskilled labor, which prevents young people from accumulating the skills that could allow them to complement intelligent robots. So, in their model, technological progress can lead to ‘long-term misery,’ each generation worse off than its prior. Scary stuff.

-There’s a growing body of evidence that, in elite professional services in particular, hiring decisions are made not on the basis of objective competence and skills, but on a vague sense of cultural ‘fit.’ Why is this? Well, in the narrow instrumental sense of the word ‘rational,’ hiring on the basis of ‘fit’ can be a ‘rational’ decision. If you’re a law firm of Democrats, and you have to choose between a Democrat or a suspected-Republican job candidate, both of about equal resume-excellence, it’d be instrumentally rational to choose the Democrat, because most of the important skills will be learned on the job anyways, and many of the lawyers at your firm might feel awkward interacting with the Republican, which would detract from your organizational efficiency. More, you, as a hirer who is politically like-minded with the rest of the firm, might think you have good reasons for believing Republicans generally don’t get along well with people—might (s)he make offensive remarks or behave selfishly toward the rest of the firm team? So you can see how discrimination on the basis of ‘fit’ is ‘instrumentally rational,’ and, hence, why it gets done. But it’s a big problem for those of us who hold to the moral ideal that people should succeed and fail in our society according to their individual merits, and not according to our culture’s taxonomies of people—and also for those of us who think that eccentrics are good for us, and cultural, affiliational, and political diversity should be rewarded and not punished. (My readers, to really feel this idea, should replace the word ‘Republican’ above with the name of a group they strongly identify with.)

-Speaking of that idea: Ethics compels us to try to make more space and opportunity in our society for people with disabilities. How can we do this with policy? Austria has experimented with giving firms tax incentives to hire more disabled workers—specifically, one disabled worker per every 25 total workers. This appears to have worked decently well on increasing employment for the disabled. It’s also, predictably, caused firms to “manipulate employment of nondisabled workers,” (i.e., hire, say, exactly 99 workers and not 100, so that they are only ‘liable’ to hire three disabled workers and not four). That’s not, by any means, proof that those costs are not worth the benefits of this policy. It’s just another reminder that public policy is really, really hard and always involves tough trade-offs and dealing with the fact that people in the private sector are, legitimately, nervous about anything that can hurt their bottom lines.

-What do people do with their extra time when unemployed? Mostly, sleep and watch TV. This is not a jab. The reason this is interesting is that there’s a big debate in economics about the possibility that people will use productivity gains with future technologies to simply work fewer hours instead of making more money—an idea that hearkens back to Keynes. But what would people actually do with all this extra time? Well, we already have some evidence, thanks to the natural experiment provided by the great recession…

-This paper finds that people who, early in their careers, engaged in entrepreneurial enterprises subsequently, throughout the rest of their careers, earn higher incomes than those who were in other respects similar to them. The authors propose as an explanation that entrepreneurship increases your “human capital” (teaching you new skills, habits, confidence, self-actualization, etc.). This strikes me as plausible. But it’s of course impossible to do a randomized study here, and so it’s also likely that the kinds of people who become entrepreneurs had a lot of unobserved good qualities from the very start, and so the “control group of comparable workers” doesn’t really do it.

-One of the more uncomfortable ideas in modern descriptive social science has been that, while most of us applaud the intrinsic value of diversity on strictly moral grounds, some statistical research has found ethnic diversity to correlate with some undesirable consequences. E.g., the most politically functional and least-corrupt states in the world are also among the most ethnically homogeneous; the most corrupt states in the world are disproportionately among those states with the highest levels of linguistic diversity. Thus, many modern liberal political scientists have even actively advocated political ethnic balkanization in states as in, e.g., between Sudan and now South Sudan. The idea is that, even in the modern world, we humans are deeply biased and tribal, and so leaders in ethnically diverse states feel driven to legislate in the interests of their own groups, rather than for the common wealth. But an interesting new paper has tried to statistically disentangle the effects of ethnic diversity versus the effects of economic inequality, and suggests that it is not ethnic diversity per se, but diversity coupled with economic inequality that leads to political dysfunction. I.e., it is in states with high levels of inequality between ethnic groups that ethnicity becomes salient, so that people start to think, “It’s those people, them, who control all the wealth and political power.” Thus these states have more adversarial politics and less support for free markets, both of which compound their problems. But the authors argue that this effect disappears as inter-ethnic inequality decreases—which might provide us some hope that, in the future, Sudan-style balkanization could be dodged  and problems solved with growing wealth and equality.

-One of the most interesting ongoing debates in the econ-policy world centers on Intellectual Property. Basically, most of us think we need some I.P., which gives entrepreneurs incentives to develop new innovations, by allowing them to profit from a monopoly on those innovations for a time. But we also all see the abuses—isn’t it crazy that in 2013, we can only do 1-click shopping on Amazon.com (since Amazon owns the patent on this ‘innovation’ which is some 14 years old)? So what’s the ideal I.P. policy? I dunno, but this guy has a model that suggests the answer is “strong, but narrowly defined,” I.P. rights in general. That is, we want to protect your monopoly on your product, just as you made it, without forbidding others to riff off of it in interesting new ways.

-Moral psychology has found that we do not condemn indirect harm as strongly as would be morally rational. I.e., rationally, it would seem equally immoral to spread dirty rumors about someone on the internet, as to hire somebody else to do the same—but moral psychologists have found that we condemn the latter less strongly, and thus let ourselves “get away with” indirect immorality more easily. These professors have made an interesting connection between this idea and our understanding of group negotiations. Specifically, we are more likely to press for goals that we would not individually feel comfortable pressing for when we are negotiating with and on behalf of a group. I.e., working with a group allows us to “diffuse responsibility” for morally bad deeds in ways that can make us misbehave.

-Companies with “well-connected” boards of directors earn “excess returns” (i.e., above the market rate). Does this seem obvious and uninteresting to you? If so, you may be misunderstanding. Keep in mind the basic financial theory here: because investors “price in” their expectations for the future of companies into stock prices, an “excess return” doesn’t just mean that the company “does well and gets bigger” in the future. Rather, it means it does even better and gets even bigger than the best financial analysts were predicting. So anything that predicts “excess returns” is almost by definition interesting and surprising. So it can’t be the case that these excess returns are explained by the fact that “well-connected people choose to get on the boards of successful firms.” Rather, there must be something causal going on. More significantly, there’s something causal going on that the investment community as a whole doesn’t yet understand and, thus, isn’t properly pricing in. It could be some surprising network effects; it could be something more corrupt.