Questioning market cap as a measure of value

By October 29, 2008Business models

Since the bankruptcy of Lehman Brothers wiped out $47bn in market cap I have been thinking that somehow we must be doing something wrong when we look to share price as a measure of value.

Now that VW shares have gone through the roof making it briefly the largest company in the world by market capitalisation I feel compelled to explore this point in a blog post.

First some numbers – VW shares are up 286% this week and 444% for the year.  By comparison the other 29 stocks in Germany’s Dax index are down.

Critically for my argument here this share price move has nothing to do with the performance of the underlying company.  Rather it is the result of Porsche building it’s stake in VW and precipitating a short squeeze.

Something is amiss here – value is being created (VW) and destroyed (Lehman’s) extremely rapidly on a massive, massive, scale in ways that have little to do with the underlying purpose of business and the economy in general – i.e. to sell products and services, employ people and make profits (hopefully).  Real people’s lives and jobs get caught up in all this.

That is the problem statement.  But I am reminded of when I shared a political science book I liked with a philosophy teacher at school – he read it and described it as “typically useless political science – all problem statement and no solution”.  I am conscious of being equally useless here.

I have no idea what the answer is, but I am pretty sure that something has to change, and that it will happen slowly and over a long period of time.

I am a believer in appropriately regulated free markets and I’m reasonably sure that short selling is an overall positive influence, helping assets to find their natural price more quickly.  So radical change doesn’t seem sensible.  Yet finding some way to reflect the fact that the value of these big companies doesn’t change that quickly seems to me to be important.  Greater transparency would obviously help.

  • Nic, I agree that the gyrations seem crazy. This latest Porsche issue is, in my view, unlikely to lead to pressure for changes in the market since, to the man-in-the-street and the politicians, this is a traditional company (that actually makes things) getting one over the speculators (or “locusts”). And the man-in-the-street is cheering over the demise of greedy hedge funds.

    The bigger issues seems to me all the ways in which people (legally) get around disclosures of stakes. Whether iusing Contracts For Differences, cash-settled options or whatever, these contracts are a) clearly a fundamentally important piece of information for valuation purposes and b) equally clearly designed to get around disclosure rules.

    So changing the rules to make disclosure of economic interest, not just voting interest, might help. Of course, there may be substantial unintended consequences of such a step. Does anyone else have a comment as to why this is *not* a good idea?

  • Nic, I agree that the gyrations seem crazy. This latest Porsche issue is, in my view, unlikely to lead to pressure for changes in the market since, to the man-in-the-street and the politicians, this is a traditional company (that actually makes things) getting one over the speculators (or “locusts”). And the man-in-the-street is cheering over the demise of greedy hedge funds.

    The bigger issues seems to me all the ways in which people (legally) get around disclosures of stakes. Whether iusing Contracts For Differences, cash-settled options or whatever, these contracts are a) clearly a fundamentally important piece of information for valuation purposes and b) equally clearly designed to get around disclosure rules.

    So changing the rules to make disclosure of economic interest, not just voting interest, might help. Of course, there may be substantial unintended consequences of such a step. Does anyone else have a comment as to why this is *not* a good idea?

  • I think the Porsche/VW issue is disgraceful but the lesson is to beware the German (and similar) stock market, not the concept of market caps as a whole.

    There are numerous assumptions one makes with stock markets. Some of these assumptions happen naturally and others need regulators to maintain. Assumptions like single share classes, liquidity at the quoted price, etc etc.

    A key assumption is that any single buyer/seller is much much smaller than the pool of available shares at the quoted price. This means that any single transaction shouldn’t affect the price materially. This is clearly not the case in the Porsche / VW / short-sellers situation, where (if I understand correctly) the free float was revealed to be about one seventh the size that people thought, and far too small to support the desired number of transactions. This created a self-reinforcing blip where as the price rose, more short-sellers needed to close out their positions (i.e. buy stock), pushing the price up further. This should not have happened.

    The corrollary of this is that Porsche / Lower Saxony / etc could not actually sell their shares to realise their ‘profit’ as the price would immediately fall a great deal.

    So what is really happening is that the German stock market has ceased to become a reliable guide to the market cap of VW, Germany’s biggest company. Which is a complete shambles.

    I remember laughing inwardly at how some (nameless) VCs on the board of my last company were very dismissive, even in the good times, of the idea of going public on AIM – comments like “Well, we’ve never done it, but I suppose [pulling face] we’d consider it”. I thought at the time these comments were surreal. But AIM suffers from many of the same issues as the German stock market – indicated stock prices do not in fact reveal the price that you can meaningfully buy/sell shares in the company, because the price changes a lot as soon as trades actually occur. So I suppose those nameless VCs deserve credit for their wisdom and foresight!

  • I think the Porsche/VW issue is disgraceful but the lesson is to beware the German (and similar) stock market, not the concept of market caps as a whole.

    There are numerous assumptions one makes with stock markets. Some of these assumptions happen naturally and others need regulators to maintain. Assumptions like single share classes, liquidity at the quoted price, etc etc.

    A key assumption is that any single buyer/seller is much much smaller than the pool of available shares at the quoted price. This means that any single transaction shouldn’t affect the price materially. This is clearly not the case in the Porsche / VW / short-sellers situation, where (if I understand correctly) the free float was revealed to be about one seventh the size that people thought, and far too small to support the desired number of transactions. This created a self-reinforcing blip where as the price rose, more short-sellers needed to close out their positions (i.e. buy stock), pushing the price up further. This should not have happened.

    The corrollary of this is that Porsche / Lower Saxony / etc could not actually sell their shares to realise their ‘profit’ as the price would immediately fall a great deal.

    So what is really happening is that the German stock market has ceased to become a reliable guide to the market cap of VW, Germany’s biggest company. Which is a complete shambles.

    I remember laughing inwardly at how some (nameless) VCs on the board of my last company were very dismissive, even in the good times, of the idea of going public on AIM – comments like “Well, we’ve never done it, but I suppose [pulling face] we’d consider it”. I thought at the time these comments were surreal. But AIM suffers from many of the same issues as the German stock market – indicated stock prices do not in fact reveal the price that you can meaningfully buy/sell shares in the company, because the price changes a lot as soon as trades actually occur. So I suppose those nameless VCs deserve credit for their wisdom and foresight!

  • Very tough problem statement indeed. While the case of VW is well explained above by Bill, the fact remains that the level of volatility we witness nowadays are not a rational market driven behavior. So we are questioning the “perfect market” assumption on which all classical financial theory is based. Maybe putting constraints on leverage ratio would help reduce volatility? Maybe increasing transaction costs would help on intraday volatility? Maybe greater transparency on most of the “innovative” financial products created in the last decade would help?

  • Very tough problem statement indeed. While the case of VW is well explained above by Bill, the fact remains that the level of volatility we witness nowadays are not a rational market driven behavior. So we are questioning the “perfect market” assumption on which all classical financial theory is based. Maybe putting constraints on leverage ratio would help reduce volatility? Maybe increasing transaction costs would help on intraday volatility? Maybe greater transparency on most of the “innovative” financial products created in the last decade would help?

  • Very interesting points you've made here. I agree with you on free markets, and you're right, radical change is not the answer, but something does need to be done.

  • Guest

    Good Question – quantitatively, it's not a good measure – but it is a measure of peoples emotions (fear v's greed) at that point in time.

    my 2 cents…

  • Guest

    Good Question – quantitatively, it's not a good measure – but it is a measure of peoples emotions (fear v's greed) at that point in time.

    my 2 cents…