Is a rising stock market a good thing?

The answer is, “usually, yes.” But the reasons why are somewhat subtle.

Some of my friends have been sharing this article by Jeff Sommer in the NYT; the article points out how well the stock market has done under the current President’s tenure. The article focuses on the Down Jones Industrial Average, a dinosaur relic of the past for measuring the stock performance (the index tracks an arbitrary and small number of companies and uses an absurd weighting scheme). But the more logical (and popular among economists) measure of stock market performance, the S&P500, has done incredibly well—up 163% since Obama’s inauguration, according to Yahoo Finance data. People like to look at how the stock market has performed under various presidents, at least partly because they think it is a measure of how well they have done on economic policy. People also like to look at how the market reacts during closely contested elections: If one party or the other unexpectedly wins the presidency or control of the House or Senate, the stock market’s reaction the next day is seen by some people as a measure of the market’s perception of the economic competence of the two parties.

In this post, I want to use just the most basic financial theory identities to show how to think through the question of when and why a rising stock market is a good thing. As I referenced above, the bottom line is that it generally is a good thing, but the reasons why are, I think, slightly more subtle than may be assumed by those who use the stock market to score political points. By exploring what, precisely, the stock market’s value represents, and why that matters, we can learn about finance and the economy, and also have more intelligent conversations about evaluating policy makers.

 

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The fundamental identity of finance:

When people buy stocks, they do so in the hope of turning their spare cash today into more cash in the future. So, when we buy a stock, we’re paying for the future cash flows from that stock. Some of those cash flows could come from payouts from the company—in the form of dividends and share repurchases. And some of those could come from reselling the asset/stock to other investors (yielding a return from ‘capital appreciation’). But those other investors to whom we resell the stock will, in turn, also be hoping to profit via dividends, buybacks, and capital appreciation. All capital appreciation has to come from some other market participant being willing to pay more for the stock in the future, ad infinitum. What this means is that, even though capital appreciation is an important part of the gains that any investor can expect to make in her own lifetime, for the market as a whole, we can think of the stock valuations and prices as a function just of dividends and repurchases.*

For simplicity, let us from now on just use ‘dividends’ in place of ‘dividends and repurchases.’ Since the market values stocks for their expected future cash flows—which we are now calling ‘dividends’—it makes sense to write the price using the following simple identity:

Price = [Expected dividends] / [Some discount rate]

I am making an abuse of notation here.** But the basic concept is there in this simple notation: Price today reflects expectations for future dividends, discounted by some amount. This is an identity. It is true by virtue of how we are defining the terms: Whatever the market’s expectation of future dividends, there must be some discount rate at which those future expected dividends are being discounted that can rationalize why the market is trading the asset at the current Price.

So that’s just an identity—what can it tell us? Well, it tells us that significant*** changes in the value of stocks can come from one of two sources: Changes in expectations for future dividends and changes in discount rates. Let’s look at each of these in turn.

 

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Dividends:

Dividends are just cash that firms can choose to pay out to shareholders. Legally speaking, shareholders are ‘residual claimants’ of the firm, meaning that they are entitled to be paid after the firm has met its obligations to pay contracting parties such as suppliers, debtholders, etc. This means that, to a rough approximation, the money that the firm can pay out to shareholders is determined by its profits. Empirically, dividends tend to reflect a moving average of firms’ profits over time. Profits that are not paid out to shareholders can be reinvested inside the firm. If the company’s internal reinvestments have the same rate of return as the company’s discount rate—and in economic equilibrium, they should be approximately equal, on average—then these internal reinvestments are equally valuable to shareholders as the cash payout would be. So, assuming that equality, short-term ‘payout policy’ (the choice of what fraction of profits to pay as dividends vs. reinvest) has no effect on the share value.

What does this mean? It means that, to a close approximation, we can use profits and dividends interchangeably in thinking about firm valuation. Practically speaking, the things that increase firm profits are things that increase dividends. It also means that we can change our exact identity above to an approximate identity:

Price ≈ [Expected profits] / [Some discount rate]

(Indeed, you may already know that “fundamental value” investors and analysts typically use some accounting measure of profits (such as EBITDA) or free cash flows, to value firms, rather than explicitly modeling their future dividend flows. The tight theoretical and empirical link between profits and dividends is the reason why they can do this.)

So, all that said, what are the implications? The bottom line is that one reason why stock prices increase is that expectations for future profits increase.

Is it a good thing when that happens? The answer is, I think, mostly yes. Usually, if market participants expect firm profits as a whole to grow, it’s because they’ve become more optimistic about consumer spending—and the things that tend to drive consumer spending, employment and GDP, tend to correlate with better outcomes in life for people as a whole.

But there could be some special circumstances when increased corporate profitability could be a bad thing. Suppose that some new policy were adopted that protected incumbent firms from competition by innovative startups. Since S&P500 firms are, by definition, large firms, expectations for their future profitability would, in this thought experiment, increase. The value of the S&P500 would increase, even as consumers would be hurt, and the value of privately-held and small-cap startups would decrease. Or, suppose that some new law were passed that greatly extended various patent protections. Assuming that S&P500 firms are net suppliers of patents, their profits would benefit, while the effects on consumers and the economy as a whole would be more ambiguous. Thus, if we used the value of the S&P500 as our summary statistic of economic well-being, we would be misled. In some policy circles, people draw a distinction between being “pro-business” and being “pro-market,” and this thought experiment captures one of the ways in which there can be a difference. Various types of policies could benefit certain corporations’ profits while being bad for the economy as a whole.

So the bottom line is that increases in the value of the stock market that are driven by what economists call “cash flow news” are usually, but not always, indicative of good news for the economy as a whole. It turns out that news about macro variables that will affect consumer spending (which tends to affect all firms in all industries) tend to swamp news about, say, legislation that will protect one industry or another from competition, etc. So most changes in expectations for corporate profitability reflect good news. But it’s worth remembering that this doesn’t always have to be the case.

 

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Discount rates:

Discount rates capture the fact that, even if I expect some stock to pay me $100, on average, next year, I’m not willing to pay $100 for it today. There are two reasons for this: First, even if I expect it to pay $100, there’s some uncertainty—some probability that it could pay more or less—and most of us are risk averse and thus willing to pay less than the average payoff. Second, it has traditionally been asserted (though the era of negative interest rates may be casting doubt on this) that there is a time value of money, such that even riskless future cash flows are discounted in the present. For the purposes of this question—since risk-free interest rates have been low and stable for the past 8 years—the first factor is most important. Let’s leave aside the time value of money for now.

What will determine by how much I discount a risky payoff of $100? Necessarily, the two things that will determine that are (1) the riskiness of the payoff, i.e., how widely dispersed are the possible outcomes are around my expectation (e.g., does it pay $50 vs. $150 with probability .5 each, or does it pay $0 vs. $200 with probability .5 each?), and (2) my attitudes towards that risk, how risk-averse or risk-seeking I am.

So what this means is that the other major source of changes in the value of the stock market is changes in discount rates, driven by changes in perceptions of riskiness as well as attitudes towards risk.

The prevailing consensus in modern finance is that most major aggregate (that is, market-wide) changes in the value of stocks are driven by ‘discount rate news’ rather than ‘cash flow news’—that is, changes in perceptions and attitudes towards risk. (Note that discount rate means the same thing as [required] rate of return, expected return, etc. All these terms can be used interchangeably, but I think that ‘discount rate’ is the most intuitive in the context of valuation.)

Is it a good thing, per se, when discount rates decrease—i.e., when perceptions of risk and aversion to risk decrease?

I actually think this is a tough philosophical question. Normatively, how can we say what our preferences and attitudes towards risk should be? Moreover, is it even possible to say how we should perceive the amount of risk that there is? Presumably, in judging changes in perceived riskiness, we would want to separate true riskiness from inaccurate perceptions of riskiness. Perhaps we think it is good when true riskiness decreases, and good when an inaccurately high perception of riskiness decreases to a correct perception—but that it is not good when the perception of riskiness becomes inaccurately low. But how do we make such a distinction between the truth and the perception? Indeed, in a deterministic world, it’s unclear what it even means to talk about the true riskiness!

If we could make such a distinction, between true riskiness and perceived riskiness, then it would seem that decreases in discount rates driven by decreases in true riskiness were a good thing. If the future path of GDP, consumer spending, and thus corporate profits, all become more reliable, and less risky, that would be desirable. But if discount rates decrease, we can never know if the economy truly became less risky, or the market fallaciously perceives it as less risky. In the end, if the economy continues to do well, low discount rates will be proclaimed, ex post, to have been justified; if not, then the previous market  high will be proclaimed, ex post, to have been an obvious bubble. But we can never know with certainty ex ante.

When the current president took office in 2009, the U.S. was still amid a major and largely unprecedented financial crisis. The low stock market valuations at the time likely reflected general macroeconomic pessimism—expectations that corporate profits might be low for some time—but also, more significantly, very high discount rates, reflecting uncertainty (perceptions of riskiness) and risk aversion. There could be a mix of institutional reasons (e.g., interlocking financial constraints) and psychological reasons for it, but the current academic finance literature is in agreement that discount rates/expected returns/required rates of return tend to be very high during recessions. It’s no surprise when the stock market bounces back from a recession low. The value of the stock market goes so low in recessions precisely because those are the time periods in which investors are most sensitive to downside risks—and that very fact, in turn, makes the stock market cheap, and thus likely to bounce back.

So the performance of the stock market over the past 8 years would seem to reflect two separate periods: First, a resolution of the extreme uncertainty of the financial crisis, which allowed discount rates to go from being very high to moderate. Most people would say that the smooth resolution of the financial crisis and its fear and uncertainty was a good thing. And second, the period of the last several years, in which decreased perceptions of and aversion to riskiness (themselves, in turn, influenced by monetary policy) allowed discount rates to go from being moderate to being very, very low. Are these very low discount rates a good thing?

We don’t know, and we won’t know, until it’s too late.  🙂

 

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Conclusion:

Significant*** changes in the value of stocks are driven by changes in (i.) expectations for corporate profits and (ii.) discount rates. Increases in expectations for corporate profitability usually, but not always, reflect good economic news. Decreases in discount rates could reflect a desirable decrease in fear and uncertainty, but might also reflect fallacious overconfidence and risk tolerance. To find out whether today’s very low discount rates are a good thing, you’ll just have to wait and see.

 

 

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* Somewhat technically, for any positive discount rate, the discounting of the ‘terminal value’ of the asset will asymptote to zero as time increases.

** In reality, since dividends are paid out over many future periods, and since discount rates can vary between periods, I should really have t-subscripts, and an infinite summand symbol. Also, depending on what notation you prefer, you can write the discount rate as the thing you multiply cash flows by (something like .94), or as the thing you divide them by (something like 1.05). We also have flexibility with whether to write the divisor as [discount rate] or as [1 + discount rate]. My goal is to focus on putting the high-level concepts in English, so my apologies if I irritate some precise readers, or those who have been previously exposed to one notation or the other.

***Technically, where I write ‘significant,’ it should be ‘unexpected,’ to reflect the fact that, in the theoretical absence of news, the stock market would still be expected to increase by its expected rate of return.

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.

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(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.

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(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.

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(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.

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(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!

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(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.

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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.

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.

The Debt Bias: Or, how good reforms do bad things to good people

I’ve been reading a lot of economic commentary and analysis around two things lately: (1) is, naturally, the negotiations surrounding the “fiscal cliff,” and (2) is Prof. Anas Admati’s argument that the best financial reform we could undertake would be to require banks to have a higher equity ratio (that is, to finance more of their assets through stock and less through debt, reducing their leverage). I hope to write at greater length about (2) in the future, but, for now, suffice it to say that both of these things center on the “debt bias” in the U.S. tax-code, a bias which piqued my interest and so which, after a little research, I should like to tell you about.

Let me start out with some econ for poets. Suppose you’re a business and you want to make a big expansion–setting up lots of new stores, opening a new R&D facility, etc.–that will cost you $1 billion.  Unless you have a lot of cash on hand (which you probably shouldn’t–it would have been wasteful to have just accumulated it) there are two ways you could fund this expansion. One, you could issue more shares in your company (that is, sell more stock to the public)–this is equity. Or, two, you could get a loan from a bank to do this–this is debt. Which option should you choose? Well, naturally, you should choose whichever one is cheaper–technically, whichever funding option’s obligations have a lower net present discounted value (the debt’s obligations being interest and principle, and the equity’s obligation being a share of profits and ownership). In reality, which one will be cheaper? Well, theoretically, since these two instruments are both providing the same good–financing–they should be about equally expensive. Think about it: if interest rates were relatively high, meaning that debt was more expensive than equity, firms would rush to issue more shares, which would reduce stock prices by increasing their supply, and eschew bank loans, which would force banks to lower their ‘prices’ (their interest rates), until the two became equally expensive. So in a perfect market, equity and debt should be about equally expensive for companies, and companies would make their financing decisions as follows:  they would fund their activities through equity if they thought that their shares were slightly overpriced, and through debt if they thought their shares were relatively underpriced.

Now, we’ve just done some typical Econ 101 theory above, about an ideal market. But in the real world corporate financing decisions are distorted. One major distortion is the U.S. tax code, which includes a deduction for interest payments on debt. The tax code does not include a deduction from dividend payments to shareholders. To the contrary, corporate profits returned to shareholders are taxed twice: once as corporate profits (just before they have been returned to shareholders), and again as capital gains (once they are in the shareholders’ hands). What does this do? Well, it gives companies a strong “debt bias” relative to the ideal market we laid out above. Because the obligations they incur from debt-financing in fact reduce their tax burdens, corporations are incentivized to rely relatively more heavily on debt, and less on equity.

Why is this a problem? Well, it isn’t always, necessarily, a problem for everyone. Indeed, if you’re a shareholder of a firm that has really great growth prospects for the future, you should be happy with debt-financing–this “leverage” means that you will get a higher share of whatever is left over once debt-obligations are paid off, than if your share had been diluted by the issuance of more equity. But the problems are twofold. First, in general, we as a society want companies to devote their analysis to trying figure out, and their energies to trying to meet, our needs as we express them in the marketplace–not make their decisions based on how best to game the tax code.  But, second, debt becomes a very big, very tangible problem during an economic downturn, when it can cause a credit crunch, a massive financial crisis, and thence a recession/depression, as you may have heard. We often hear debt analogized to “leverage,” because it makes the good times better for companies’ owners (shareholders) and the bad times worse. Consider this super simplified model of a firm buying one asset in one year, with a 2% interest rate: If you’ve financed a $100 million asset through $50m of equity and $50m of debt (a debt-equity ratio of 1 to 1), if the value of that asset suddenly declines to $85m, you’re still easily okay–you can pay back your creditors their $51m, and still have $34m left, which is now the value of your shareholders’ stake, a loss of $16m for them. But if you financed that through $10m of equity and $90m of debt (a debt-equity ratio/leverage of 9 to 1), the same decline in the asset’s value will bankrupt you: You owe creditors more than you have, and so your shares are worth less than nothing, and you have to enter bankruptcy. If you get the conceptual gist here, you can probably also see how, in good times, when firms are making high profits, “leverage” (a high debt-equity ratio) can increase the profits that are returned to shareholders. (But, and this is a bit technical, it does not technically increase shareholder value, because the leverage makes the expected return-on-equity riskier.) It also makes it much easier for firms to slip into bankruptcy when the times are not as good as they had predicted.

So what, then, is the problem with leverage if it just helps shareholders on the upside, and hurts them or causes bankruptcy on the downside? Why should I care if I’m not a major shareholder, or involved in any way with a highly-levered firm? Or if I am a shareholder, shouldn’t I be okay with this as long as I have a diversified portfolio that is collectively non-risky? The problem is that, during a credit crunch and financial crisis, bankruptcy is contagious. That is, when a highly-levered firm (which could itself be a bank–see my upcoming post on Admati) can no longer meet its obligations and enters bankruptcy, it is failing to pay out a cash flow that a bank had been depending on to finance its own activities. So that can send that bank into bankruptcy, or leave it unable to roll over the debt of another firm, sending that firm into bankruptcy. This is basically what a “credit crunch” is–everybody being so indebted to everyone else, that a small economic downturn can cause a string of interlocking insolvencies–and this is pretty much the story of what has happened in the economy from 2007-present. If companies had had less debt, and financed more of their activities with equity, an economic downturn would have caused their shareholders to take an unpleasant hit, but it would not cause this contagious domino-effect of insolvency.

A lot of what I’ve written about firms is also true of people, except for the fact that we people don’t really have the option (yet) of getting outside equity-financing (though some are proposing to equity-finance college loans–more on this later). For example, we humans have a mortgage-interest deduction, which provides us an incentive to take out relatively larger mortgages on our homes. There are a couple of problems with this. First, since the real-estate market is in reality largely an arms-race to get into the best school district possible, people generally buy the most expensive house they can afford, and so, according to many economists, the economic value of the mortgage-interest deduction is simply capitalized in higher home prices–i.e., in the aggregate, it doesn’t provide any easing of financial burdens to homeowners at all. Second, it distorts the market for buying vs. renting property–and there’s no particularly compelling reason to do that. And third, and most importantly, as we, again, saw in the financial crisis, more debt makes it easier for you to get wiped out by even small changes in the value of your assets. Suppose bad employment prospects have made it difficult for you to make your mortgage payments–if, in addition, the value of your house has declined, leaving you “underwater,” you won’t be able to refinance your house, and so you’ll default. That will reduce the cash flow to the bank that is entitled to them which, in turn, can cause Lehman… You get the picture. So personal bankruptcies, just like company bankruptcies, are contagious, and they become likelier and more harmful the more debt we all have.

***

I hope that you, gentle reader, do not spend as much time reading economics commentary as I do (because then what use would I be to you?), but one thing I’ve noticed is that almost all econ-theory minded people want to get rid of all of these distortions. Everyone seems to agree that the ideal tax reform involve lower rates, while getting rid of loopholes and deductions, such that we can actually raise more revenue, while imposing fewer distortions on the marketplace. There’s a consensus among them. But if there’s a consensus, why can’t we get some policy and legal changes done? The answer, of course, is “vested interests.” But that term sounds mean, and derogatory, and, more importantly, it understates the difficulty of our challenge.

Because, in this case, the term ‘vested interests’ doesn’t just mean super-rich super-evil tobacco lobbyists, or some such fun-to-hate villain, but actually literally means your mom and dad. Even if your mom and dad have already finished paying off the mortgage on your house, getting rid of the mortgage-interest deduction would hurt them, because it would reduce the sale-value of their house, because it would hurt the real-estate market as a whole (since new buyers won’t get such large mortgages if they can’t write them off). And the same goes for the corporate interest deduction–if we eliminated it, a lot of medium-size firms would  lose a lot of money when they can no longer write off the interest on bonds they issued a decade or two ago. And the same goes for a lot of other loopholes:  if we get rid of the federal deduction of state income taxes, medium-high-income people in high-tax states are going to get badly hurt. All of these people were, when they made these decisions, responding rationally to the incentives our public polices had put in place. They formed rational expectations for the future based off of those expectations. They were good people doing the right thing, in the circumstances and policy landscape that they were presented with, and now the policy changes that we are proposing are going to hurt them and disrupt the life path that the old policies had led them to expect. These people are, quite justly, going to be very upset if their representatives do it.

This is why reform is hard. 

Nonetheless, I’ll reiterate that we really should do the right thing and eliminate these distortions and tax loopholes if we can. It would obviously be wrong to leave bad policies in place forever. But the longer we leave them in place, the more and more good, rational, reasonable people build their lives around those policies, making them even more costly to be rid of in the future. So the very best time to take the plunge is right away.

Financial Transactions Tax: For and Against

In recent weeks, as we’ve debated tax policy in light of the looming “fiscal cliff,” one idea that has been floated as a good way to generate extra revenue is a Financial Transactions Tax. It’s been getting a lot of support, including from Elliot Spitzer and Ralph Nader.  Basically, a financial transactions tax (FTT) would be just that — a tax levied on each incident of a financial transaction, calculated as a very small percentage of the face value of the asset. The percentages we hear proposed are often in the range of 1 cent on every $100 transaction (i.e., .01%).

Would an FTT be a good way to raise extra revenue (or replace other revenue sources)?  To answer this question, I think we need to answer two others. First, what is it that we want traders and trading in the finance industry to do? And, second, how would an FTT impact that?

There are a few things we definitely want from financial markets. First, we want them to use our savings to invest in productive ventures that can satisfy human needs now and in the future–that is, we want them to efficiently allocate capital. Second, we want them to help us redistribute risk — futures contracts on wheat, for example, allow more of us to share the benefits to, and pad the harms to, farmers whose harvests are subject to unpredictable weather events. And third, we want the assets traded in financial markets to be liquid–if you’re a saver/investor who suddenly needs/wants cash, you want to be able to sell your claims to any financial assets quickly, and at a fair price. That liquidity will encourage you to get into the market in the first place, and make your life (or, if you are a business, your financing projects) a lot easier. Now, venture capitalists, investment bankers, etc., help provide the first kind of thing–connecting our savings to long-term funding for valuable projects, etc. But shorter-term traders are essential to providing the latter–liquidity. Because traders are trading these assets on short-term bases, they ensure that there is always a market for the asset they are trading. Liquidity is why you always know, up to the minute, how much your stock portfolio is worth (the $ value you see is, fundamentally, the sum of the last transactions traders made in the underlying assets), but you’re never quite sure exactly how much your property could sell for.

Financial Transactions Taxes could raise a lot of revenue, according to most estimates. But would they detract from these important functions of financial markets? The simple answer to that is: it depends on how large the taxes are. FTTs wouldn’t really interfere with the first function of financial markets too much– if you’re a venture capitalist, you’re not going to turn Facebook away just because you might need to pay 2 cents for every $100 when it’s time to sell your shares. But they could, if large enough, reduce the liquidity of some financial markets, by reducing the viability of shot-term trading. For example, if you’re a trader placing a large, short-term, highly-leveraged bet on a small price-movement you’re predicting in that asset, even a small tax could make that bet unprofitable. It’s pretty straightforward: a .02% FTT makes each trade .02% less profitable, which could cut out some short-term, highly-leveraged trades, by making them unprofitable; but it would have less impact on longer-term trades that predict a larger price movement. So FTTs can definitely theoretically reduce liquidity. But the important question is, would they hurt market liquidity enough to hurt the real economy? That’s more debatable. My own sense is that it’s hard to believe that, with American capital markets as robust and deep as they are, a .01% FTT could clog markets enough to hurt the real economy, through making savers nervous about investing the stock market, or making it hard for companies to cash out when they want to. More, its advocates claim there could be broader benefits: FTTs would decrease the profitability of super-high-frequency trading, which is generally considered socially unproductive. By curbing high-frequency trading, we would both incentivize America’s brightest minds to find more socially productive outlets, and we could also forestall events like the 2010 flash crash. We would give investors more incentive to try to predict bigger, more significant market movements, and be less focused on temporal volatility. A very small FTT, its supporters consequently claim, could raise some extra revenue from the finance industry and improve the stability and long-term focus of financial-markets trading, without substantially interfering with the functions of financial markets.

I think it’s a pretty persuasive argument, especially if we’re talking about FTT’s on the lower end of the range proposed–.01%, etc.

Why might we oppose an FTT? I can think of four possible objections: 

(1) You might think, for much broader ideological reasons, that the amount of revenue the federal government takes in is quite enough already, thank you very much. You might think raising extra revenue will just give it more room to continue to fail to curb expenditures. But if this is your objection, you should probably still at least be able to support substituting an FTT for other, worse, more distortionary taxes–i.e., you should get behind a revenue neutral reduction in income or corporate taxes offset with a higher FTT.

(2) You might worry about the potential for offshoring. That is, you might think America’s global economic leadership is an inherently good thing, and worry that, if the U.S. institutes an FTT while its competitor nations do not, then firms that profit from HFT may move offshore, focus more on foreign exchanges, pressure other companies to list abroad, etc., etc. Theoretically, this could drive the finance industry–and the larger economic ecosystem it helps support–out of NY and Connecticut. That could be bad.

(3) You might worry that, given popular attitudes toward the finance industry, an FTT, once implemented, would inevitably be raised to the point where it would reduce market liquidity. This is a slippery slope argument, which is formally considered a logical fallacy, but in this case seems like a plausible prediction, and something to be guarded against.

(4) You might also worry how the compounding effects of the FTT could eat into, say, someone’s retirement savings invested through a mutual fund. I don’t have the energy to do the calculations right now, but it seems to me that even a .02% tax, levied on a portfolio that turns over, say, three times per year, could add up to a significant dent over 30-40 years. I would hope that, if we did levy FTTs, we might be able to find some way to make exceptions for long-term retirement savings invested through mutual funds by non-super-rich people, etc.