The Myth Of Market Cap Exposed

Authored by Thad Beversdorf via SpendIndie.com,

More than $2 trillion in cash distributions will be gifted to shareholders by S&P 500 CEO's this year.  More than ever before. But why? 

Why do CEO's distribute cash to secondary market speculators?  These speculators haven't provided any capital to the balance sheet and haven't added to the income statement or cash flow statement of the companies they are speculating on.  So why do CEO's spend so much effort and capital appeasing them?

Market cap is the benchmark by which a company distributes cash (i.e. div yield).  But market cap, as determined in the secondary markets, is a theoretical asset that doesn't generate revenue, profit or cash flow for the firm.  Meaning cash payments are tied to an 'asset' that has no relevance to a firm's operations.  

Paying dividends against an non-producing asset i.e. market cap that generates no return for the company is incredibly destructive.  There becomes a dangerous disconnect between the return on capital the company raised/invested and the cash distribution.   

In this sense, market cap is a massive hindrance to the firm's capacity for productive investment as capital is eaten up paying out against an asset that hasn't generated any return.  The destructive force of this connect is exacerbated by the stock buy backs whose sole purpose is to drive market cap higher.   

And for what benefit?  What does a higher market cap or a higher valuation do to improve the operation and long term success of the business?  Historically market cap was a represenation of operational performance and expected future growth but it has now become the objective. 

Apple's numbers are mediocre.  But they are distributing $110 billion in cash this year so it doesn't matter.  They hit a trillion dollar market cap.  That puts its price-to-sales in line with Amazon, which has a 3 year revenue growth rate 7x higher than Apple's (32% vs. 4.5%).  Amazon's growth rate continues to accelerate while Apple actually lost overall marketshare dropping from second largest to the third largest seller of smartphones, something that hasn't ever happened.  And so why would a firm that is losing marketshare not be putting its capital to work?

The proof is in the pudding.  Amazon doesn't distribute cash to speculators.  It attracts speculators by driving expected future growth.  The rest of the market is attracting speculators by paying them cash.  In effect, CEO's are investing in market cap today rather than growth tomorrow.  The result is that Amazon is in a league of its own, trouncing incumbants in any sector it enters because it invests in being better.  

Adding to the absurdity is that these disconnected and disproportionately large cash payouts are going to a group of speculators that have never contributed to the balance sheet, income statement or cash flow statement.  Buffett via Berkshire's share of Apple's $110 distribution is more than $6 billion.  Why?

Note in the following chart the left tail of the chart is the Great Depression era and the right side is today. 

The moral of the story is that when market cap becomes the objective of capital rather than a representation of productive capital allocation, productive investment is replaced with financial investment. 

When market cap is being driven by something other than expected future growth derived from productive investment it is coming at the cost of expected future growth due to lack of productive investment.  Read that again.

And look, if just one company was doing this it isn't an issue but when all corporations are doing this the result is financial market acceleration and macroeconomic deceleration and ultimately contraction.  Sound familiar?

Markets have accelerated to record highs while economic growth has decelerated to record lows. 

At this point financial markets require perpetual money injections to prevent market cap from collapsing. And so the economy simply cannot compete with financial markets for available capital. 

Enter the Fed with rate hikes and the end of the bubble cycle.  A market cap reset is required for future growth.  The Fed is aware and the beginning of this bull cycle end is now in play.

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At Spendindie we encourage society to take a more cognitive role in reshaping a system currently benefiting far too few.  As consumers we hold a tremendous amount of potential economic power. 

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Comments

dwboston Thu, 08/09/2018 - 15:18 Permalink

Simple - the "secondary market speculators" actually own the company.  If enough of them band together, they can oust management, so management appeases them with payoffs.  Big difference between Tim Cook and Jeff Bezos - Bezos is a founder with control while Cook is a temporary seat-warmer.

Yen Cross Thu, 08/09/2018 - 15:26 Permalink

  Because if they didn't their share prices would crash.

   This statement is beyond ignorant.

  "These speculators haven't provided any capital to the balance sheet and haven't added to the income statement or cash flow statement of the companies they are speculating on.  So why do CEO's spend so much effort and capital appeasing them? "

  By the simple fact that "these" speculators invest in your stock, adds cash to your income and cash flow statements.

OverTheHedge Yen Cross Thu, 08/09/2018 - 17:31 Permalink

The people who bought the initial stock offering, yes. After that? Once a share in a company has been sold twenty times, does the company have any invested allegiance to the new shareholder? Only in terms of the current share price, and what that means for the CEO bonus structure.

Not sure that there is a better way, but CEOs should be paid on performance, not share price.

In reply to by Yen Cross

PT OverTheHedge Thu, 08/09/2018 - 21:01 Permalink

... and why did the people buy the initial stock offering?
Because they thought they were going to get a better return on investment than what they got from anywhere else AND that they could quickly offload those shares if they did not get the return they desired.
How do they get that return?
Dividend yield.  So in order to buy a stock instead of simply leaving the money in the bank, they need a dividend yield.
And if they do not get that dividend yield then they need to make up for it with Capital Gains.
So now the question becomes, how much yield are investors prepared to forgo today in return for Capital Gains tomorrow?  Now we have the old risk / return thingy.
But what if there is no dividend and there is no Capital Gain?  How hard is it to liquidate when you get pissed off?
Well, if you knew you could not liquidate then would you not demand a much larger Capital Gain or a much larger dividend yield to compensate?
So yes, the secondary market is very important, otherwise either Capital Gains or dividend yield or both would have to be much higher in order to compensate for the fact that once you put your money in, it is much harder to get it out.

So I guess now we are left with, why is dividend yield calculated from market cap and not from nett profit?  And why should the difference matter?  Shouldn't market cap be roughly proportional to nett profit?  Okay, not if the company is investing heavily in growth, hence the problem put forth by the article - dividend payouts rob from Capital when Capital investment is greatest.  But then, with low yields no-one will invest when the stock needs it most. 

Who cares if it is only investment on the secondary market anyway?  Banks.
Banks worry that if the company goes belly-up then the only way they can get returns on their investment is by liquidating Capital.  How much will they get?  Some function of Market Cap?  So the higher the market cap, the more the company can borrow?  So sure they can't get the additional cash from the investors but due to the higher market cap they can borrow more from the banks?

So yield as a function of market cap encourages secondary speculation even when the profits suggest this is a bad idea but what the company loses in paying out dividends they more than make up for with a higher market cap that allows them to borrow more than what they would have saved in paying out dividends anyway.

???

PT has reached the limits of his knowledge and welcomes smarter people to tell him why he is wrong or to further develop what he has already written.  Thanks.

 

In reply to by OverTheHedge

Don Sunset Thu, 08/09/2018 - 15:37 Permalink

Are enough suckers on board yet?  It's been almost 10 years now as the unsustainable manipulation piles up and up. The cost will realized at some point.  No fear when the herd goes over the cliff.

All Risk No Reward Don Sunset Thu, 08/09/2018 - 20:53 Permalink

Exactly.

“The new law will create inflation whenever the trusts want inflation. From now on depressions will be scientifically created.”
~Congressman Charles A. Lindbergh, after the passage of the Federal Reserve act 1913.

“This Act establishes the most gigantic trust on earth.…When the President signs this Act, the invisible government by the Money Power, proven to exist by the Money Trust Investigation, will be legalized.…The money power overawes the legislative and executive forces of the Nation and of the States. I have seen these forces exerted during the different stages of this bill.…”
~Congressman Charles A. Lindbergh, referring to the act which established the Federal Reserve. Congressional Record, Vol. 51, p. 1446. December 22, 1913.

In reply to by Don Sunset

Pindown Thu, 08/09/2018 - 16:13 Permalink

He´s got a point! If you can´t deliver what you are worth, you are either a beautiful woman or you will get broke. Waiting for the everything crash patiently.

tangent Thu, 08/09/2018 - 21:52 Permalink

This article is missing a lot of explanation. "Why do CEO's distribute cash to secondary market speculators?" Who says this happens? How? Is this a reference to stock buy-backs? "Market cap is the benchmark by which a company distributes cash (i.e. div yield)" Says who? Example? I'd like to see examples of investments being driven by market cap because its hard for me to believe. I'd also like to know what finance executives are basing dividend on market cap.

Let it Go Fri, 08/10/2018 - 06:25 Permalink

The IMF warned last year that 22% of U.S. corporations are at risk of default if interest rates rise. History has provided countless examples of inopportune, if not reckless buybacks as they put the short-term benefits of buybacks before debt-management.

As of 2015, just 30 firms accounted for half the profits of all publicly-listed U.S. companies, down from 109 in 1979. Only by accumulating debt have many laggards been able to afford the buybacks necessary to keep stock appreciation stable.

 http://brucewilds.blogspot.com/2018/03/stock-buybacks-driving-market-where-it.html

PatriceBateman Fri, 08/10/2018 - 10:36 Permalink

My god what a fucken retard. Does this moron understand the basics of how equity markets work? Owning a share makes you the part owner of the company, it doesnt matter if it was purchased at the IPO or traded afterwards. Of course the earnings need to go shareholders, where da fuck else should they go?? 

If a company has got no serious prospects for growth, as is the case currently with apple, they better pay out those dividends. The allocation of capital is possibly one of the most important decisions, and it would be careless to invest it in assets if their isn't legitimate growth potential in that arena.