The Emperor’s Clothes: How Do Markets Value Companies?

by Grace Blakeley

7 February 2018

Rafael Matsunaga/Flickr

What do Capita, Carillion and the Dow Jones industrial average all have in common?

Carillion has now been forced into liquidation and has ceased trading, having issued several profit warnings before investors discovered it was essentially a giant Ponzi scheme whose liabilities massively outweighed its debts. The much larger Capita is currently being forced to consider laying off a substantial portion of its 50,000 employees and consolidate its operations after its share price fell almost 50% last week. Meanwhile, on Monday night the Dow Jones plunged almost 1,600 points in a day – the largest single slide in its history.

In other words, until recently, they were all overvalued. These individual events all raise an interesting question: how do markets value companies in the first place?


The value of a company, and therefore the price of its shares, should be determined by a set of indicators known as ‘fundamentals’. A company’s fundamentals should let investors know whether a company’s share price is undervalued (and therefore worth buying) or overvalued (and therefore worth selling). There are a variety of different metrics one can use for this – different investors have their favourites – but broadly speaking they compare either what you can expect to earn from a share relative to what you pay for it (e.g. its ‘price earnings ratio’), or the market value of a company with its underlying assets (e.g. its ‘price to book ratio’).

Carillion and Capita were both highly valuable companies according to stock markets just a few weeks ago. Both companies, especially Carillion, were paying out significant dividends, and both looked as though they had more than enough assets to cover their liabilities. But as pointed out recently in an excellent piece by Adam Leaver, Carillion’s tangible fixed assets (e.g. machinery and land) were just 3.3% of its total assets, whilst intangible (i.e. nonphysical) assets represented almost 40% of its balance sheet. Capita’s balance sheet didn’t look much healthier, but both companies opted to borrow against these intangibles to finance current spending. By the time it issued its third profit warning, Carillion didn’t even have enough assets to allow it to enter administration before being liquidated.

Meanwhile, the Dow Jones reached its highest point in history last week, partly due to Donald Trump’s corporate tax cuts. The cuts were intended to boost corporate profitability at a time when an historic amount of national income is already accruing to capital. With investors failing to price in the inevitable interest rate rise that would result from the cuts, the effect was to send already overvalued equity markets skyrocketing, creating a huge amount of volatility. This volatility was exacerbated by the use of index-tracking funds that follow the peaks and troughs of the market with eye-watering speed.

Beauty contests and bubbles.

John Maynard Keynes would not have been at all surprised that the markets failed to value any of these things correctly. Rather than investing based on the actual underlying value of companies, Keynes argued that investors made decisions based on predictions about the likely future value of the stocks they bought. This kind of thinking encourages the kind of herding behaviour behind most financial bubbles and crashes. In other words, what Keynes called the ‘beauty contest’ between firms is what determines the price of equities, not the underlying value of a company.

The Keynesian view of investment has been borne out in recent years across the developed world. Before Brexit, a host of different issues had coalesced to make UK and US equities look incredibly expensive. Slow growth in the real economy meant there were fewer places for investors to put their money, global trade had slowed dramatically for the first time in decades, and the volumes of capital flowing across borders in the form of foreign direct investment (FDI) had also fallen sharply. Investing in equities in blue chip companies in the rich world started to look like the only option for many investors.

But what really made US equities so expensive was the Federal Reserve’s quantitative easing policy. In the wake of the financial crisis, the Fed couldn’t set interest rates low enough to stimulate the economy. ‘Quantitative easing’ (QE) was a way to get around this problem. The Fed printed new money to buy government bonds from commercial banks. The banks then used this new money to invest in assets like equities.

This had the effect of making public and private borrowing cheaper, but it also served to dramatically increase the prices of assets like equities, and therefore enrich those wealthy investors who held a lot of these assets. The same programme was pursued in the UK, and this is what largely explains the massive increase in the prices of UK shares. The QE-inflated bubble is reflected in the share prices of Capita and Carillion, which both shot up in around 2012 just after QE begins.

Brexit brought the UK bubble crashing to a halt – ironically this was in many ways a welcome revaluation. The US, on the other hand, was called the most expensive market in the world earlier this year. As Joseph Stiglitz argues, the boom should be taken as evidence of investors’ short-sightedness in believing that the tax cuts might lead to a boom in corporate profits, ignoring the world of 2007 and what followed in 2008.

This affects us all.

The reason any of this matters is that this kind of financial instability affects us all. Whether you’re saving for your pension, trying to start a business, or looking to buy your own home, the state of the markets has a significant impact on the lives of people living under financial capitalism. And in an economy in which investment decisions are based purely on the potential for speculative gain rather than the underlying potential value of a company, the likelihood of resource misallocation is huge. Think about all the productive uses that could have been found for all the investment that went into the ultimately worthless shells of Capita and Carillion. As was made very clear in 2007, our financial system is wrecking our economy.

Financial markets don’t have to work this way. Properly regulated markets should serve to allocate capital efficiently in order to support investments that ultimately benefit us all – from public infrastructure projects to life-saving new technologies. In order to move towards such a system, the public sector must start playing a much greater role in providing stable investment opportunities for ordinary investors, whilst also providing capital for risky but potentially transformative innovations. As Mariana Mazzucato points out, neither the internet nor the iPhone would have been possible were it not for innovation funding provided by the American state in the 1990s.

Such reforms would go some way to redressing the balance of power in financial markets, but they will not solve the deepest issue with modern capitalism. As Keynes pointed out, the massive concentration of wealth and power in the hands of a few speculators has had acutely detrimental effects on our economic system. Reducing this power will require radical transformations in capital ownership in order to truly socialise wealth, making it work for public good rather than private gain.

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