No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Sixteen: Valuing the Future - Concepts in Capital & Finance 405 With an annual CF of $50,000 and I = .05, the present value of this bakery is $1,000,000. The owner of this bakery could sell this bakery for a million dollars if she decided to exit the bakery business. Let’s say the business was a group of 50 such bakeries, such that the value is $50,000,000. If our entrepreneur wants to cash out of her bakery empire, she needs to find someone who both has $50,000,000 and wants to go into the bakery business—that might be hard to do! Another option is for Anne to incorporate her business and sell ownership shares of the firm. She might create 1,000,000 shares, with a value of $50 per share. In most countries, this would be a joint-stock company which offers some very convenient legal benefits. First, each share corresponds to fractional ownership such that a shareholder is entitled to a fraction of the earnings of the company. Second and very important, each shareholder has limited liability , which means they are not liable for more than their investment should the company go bankrupt; the shareholder’s other assets cannot be taken. Third, if part of the company’s ownership dies, there is no impact to the operation of the firm; ownership is separate from the operation of the company. Anne may decide that it would be easier (and more profitable) for her to sell her shares on a publicly traded stock exchange. A stock exchange is a market where ownership shares of stocks can be bought or sold. The exchange may be a physical location, such as the New York Stock Exchange (NYSE), or it could be an electronic exchange, such as the National Association of Securities Dealers Automated Quotations (NASDAQ). By selling her shares on the publicly traded markets, Anne will find more people able to place a value on shares. Publicly traded stock markets are therefore one of the most important institutions in a market economy. Stock markets provide a social imputation of value based on the combined knowledge of all the investors in the stock market. This social imputation guides the allocation of scarce capital to those investments most highly valued by market Limited liability: An individual investor’s liability is limited to the amount of his or her investment should the corporation go bankrupt. MAKING A MARKET When a market price emerges from the millions of buyers and sellers, the resultant price is not what everyone thinks it’s worth—whether we are talking about a Pepsi or a share of IBM stock. Only the marginal buyer and seller think it is worth the price that it sells for. There are an equal number (at least in terms of ability to commit financial resources) of “bulls” and “bears” on either side of a trade. If IBM is currently selling at $50 per share, half of the market thinks it is worth less than $50 (the bears), and half think it’s worth more (the bulls). The divergence in opinion (or expectations) is precisely what makes a market: for everyone who wants to buy a stock because he thinks the price is rising, there must be someone willing to sell the stock because he expects the price of the stock to fall (at least relative to the value he places on other alternatives—either in investing or consumption). Further, these divergences in expectations continually change as time progresses and new knowledge is obtained, such that market prices of capital are constantly in motion as investors “price in” new information in the value of a capital asset.