This is a fundamental truth for all commodities and valuable things. They're fungible, but not positionally identical, and not linearly aggregable. This is why we prefer to talk about "utility" over "quantity" in game theory discussions.
Market cap is meaningful in some sense - the price in a liquid market isn't just randomly the last price used, it's the equilibrium price of a marginal share. That's the price that current holders don't want to sell for less, and people with money don't want to buy or more. That equilibrium is real information.
But it's still only for the marginal share (or block). We don't know what the value/quantity curve looks like, or how it will change if demand changes. A thing is worth what it will bring. We just don't know what the total mass of shares will bring.
We don't know what the value/quantity curve looks like, or how it will change if demand changes.
This is untrue. Order book data is available for the right price (and although it doesn't capture all capital flow, sophisticated algorithms can infer the full curves with high accuracy). For what it's worth, many finance firms view the market price as basically noise and use order book curves as the "real" price input. Most contracts that depend on equity value will calculate it by VWAP over the last 30 or 90 trading days, which is a much better estimate of true value.
I think it is much less bogus than you think. Yes, price would change if a large number sell or buy, perhaps that would be more of a statement on liquidity than bogusness.
At anytime, all shareholders are able to sell their shares at the market price, therefore anyone still owning believes the price is at or less than it's true value, likewise anyone has the option to buy at the current price so (barring non-idealities) everyone else thinks the price is potentially higher than its true value, therefore market capitalization is much less bogus as it is the price where there is balance between people's capital put towards buying and selling bets on the true value (of course lots of assumptions: low transaction costs, ignoring tax treatment, spherical cows, etc, etc).
If you believe that market capitalization is meaningful, it is probably because of that conceptual error, combined with social validation. Since it is a common error, it seems correct. There are many other examples of common errors due to fallacies. People create language games that seem meaningful because people play them.
I think this post in general lacks a great deal of nuance and understanding, which would normally be fine except that you adopted such an arrogant tone that it was frustrating to read. I promise people in finance understand that the market cap isn't literally how many dollars it would cost to buy all of the shares. Even Google's AI summarization says that. That doesn't make it a useless metric, and market cap remains a very important input for many processes in trading.
People think of the price metaphorically as a physical property, such as mass.
Who are these people, and where can I bet against them?
you adopted such an arrogant tone
I didn't write this post. I'm just sharing it. If you want the author to read your comments, then you should post them on his blog.
If you're sharing it, but don't endorse it, you should say that you don't endorse it. If not, readers have a right to assume that you endorse it.
(And you seem to be in this limbo where you're sort of endorsing it but sort of not.)
Purple fire accused me of having an arrogant tone and he/she is assuming that I'm the one who wrote the essay. Neither of those assumptions are true, and I was simply pointing that out.
There's nothing wrong with posting an essay to see what other people think about it. I never claimed to be an expert on economics.
There's no way for anyone to know that you didn't write the essay unless they already know that your username isn't an alias of the writer. You didn't write "here is a post by someone else" or anything else which makes clear that the post is not yours, let alone that you don't endorse it. In fact the essay starts with "In this essay, I will", making the normal assumption that the only person whose username is attached to the post is who "I" refers to.
This post is a link post that links to the TheWaywardAxolotl. I figured that more people would read the essay if the text was displayed directly on LessWrong, so I copied the text from the blog post and pasted it into the LessWrong post. The author has said that he doesn't mind people doing this as long as they include a link back to his blog. I'm sure I'm not the only one on this forum who shares content that I didn't write myself. It's pretty normal to do that on social media.
There's no way for anyone to know that you didn't write the essay unless they already know that your username isn't an alias of the writer.
My user profile has a link to zerocontradictions.net, which is clearly my website. That URL is shown when anybody hovers over my username on this site. This link post links to the TheWaywardAxolotl, which is clearly a different website. The username on that blog is also displayed as "Blithering Genius", not "Zero Contradictions". There is nothing on Blithering Genius's blog to suggest that I own it, so it's weird that Purple fire is jumping to the assumption that I wrote the essay.
making the normal assumption that the only person whose username is attached to the post is who "I" refers to.
Yes, that's how the essay appears on TheWaywardAxolotl, which is clearly not my blog. It's also how it appears on this LessWrong post, since I copied the text into the post. "I" and "we" are used throughout the essay, so it's not easy to edit out the first-person language. But since you insist, I edited the post to include a disclaimer at the top that I didn't write the essay and I'll do that in the future as well.
let alone that you don't endorse it
I agree with the essay, but I'm also open-minded, so I shared it to see what other people would say about it, because it's possible that some people have knowledge and thoughts that I hadn't thought about. I think that purple fire made some interesting criticisms which might be right, so I told him/her that he/she should post them on the author's blog if he/she wants the author to read them.
So, this is true in two (not really independent) senses I can think of. First, in most cases, there isn't enough money chasing shares to sell all shares at the current price. Second, the act of shareholders selling in large numbers is new information that itself changes the price. The current price is a marginal price, and we don't usually know how steeply the rest of the price curve slopes at larger volumes for either buying or selling.
There is a sense in which the price approximates an intrinsic property of the shares that you can add up or multiply by the number of shares. Each share gives you a vote in the shareholder assembly and an equal portion of the dividends. If you had all the shares, you would own the company and in principle could pay yourself as much as the company can afford in dividends.
How much the company can afford to pay in dividends in the future is basically how much net operating profit after taxes (NOPAT) the company will have.
If you have a prediction of the future NOPAT of the company, it implies a present value for the whole company and its shares assuming all of it is cashed out as dividends. It is commonly assumed that in most cases the market price of shares oscillates around a rational expectation of future NOPAT, in which case it would be a reasonable approximation to something that you can semantically multiply by the number of shares to get the overall value of the company.
This is incorrect. NOPAT refers to a company's cash flows before mandatory debt repayments, recurring capex, and interest expenses. It's used to compare companies without considering differences in capital structure; it is not a good measure of how much the company can afford to pay in dividends. Many companies that file for bankruptcy have positive NOPAT and yet strictly 0 equity value. You're thinking of levered free cash flow.
I stand corrected. Although the broader point about share prices noisily approximating a discounted expected cash flow which can be added or multiplied still holds
This might just be a writing critique but 1) I just skipped all the bricks stuff, 2) I found the conclusion was "shares aren't like bricks." Also like what should we use instead?
Note: I didn't write this essay, nor do I own the blog where it came from. I'm just sharing it to see what other people think about it. The essay text is displayed below this line.
In this essay, I will debunk the concept of market capitalization.
But first, let’s consider something else: the mass of a pile of bricks.
Suppose that I have a pile of identical bricks. I want to know the total mass of the bricks for some reason. So, I measure the mass of one brick on a scale. The mass of one brick is M. I then count the bricks. The number of bricks is N. I then caculate the total mass of the bricks as M × N.
M × N is meaningful. There are N units of size M, so N × M represents the total size of the units together..
The meaning of M × N is “the total mass of the bricks”. It is not just “M × N”. Note that I could use another method to get the same quantity. I could put each brick on a scale, measure its mass, and add up all of those numbers. If I had a really big scale, I could put all the bricks on the scale together, and measure the total mass directly. The meaning is not the method. The meaning is what the number represents.
Now, let’s consider market capitalization.
The market capitalization of a company is the current share price times the total number of shares. For simplicity, let’s assume that all shares are identical. So, if the current price of a share is P, and there are N shares, the market capitalization is P × N. This number supposedly represents the market value of the company (all the shares together).
This is very similar to the example of the bricks. You might never give it a second thought. But let’s give it a second thought.
The mass of a brick is a property of the brick. It is a stable property, and it does not depend on other things. Since the bricks are identical, it is semantically valid to multiply the mass of one brick by the number of bricks to get the total mass of all the bricks together.
Is this true for shares?
No. The current market price of a share is not a property of the share. It is a property of the last transaction: it is the price at which the last share was sold. We could also say that it is a property of the market in which the shares are traded. The market price could be defined simply as the price of the last transaction, or we could average over a few recent transactions. Either way, P is not a property of every share of the company, in the way that M is a property of every brick in the pile. P is not a property of any share.
There are not N units of size P, so P × N is not semantically valid. It doesn’t represent the total price of the shares. There is no such thing as the total price of the shares, because they are not traded as a unit.
If you tried to buy all the shares of the company (or a large number of them), the price would increase, due to increased demand. If you tried to sell a large number of shares, the price would decrease, due to increased supply. This shows that market capitalization is bogus, but it is not the reason why market capitalization is bogus. The reason is that market capitalization is semantically invalid.
For a mathematical function to be semantically valid, it is not enough that the inputs are meaningful. The mathematical operations must also be meaningful. P is a meaningful input: it is the price of the last transaction, and it is correlated with the price of the next transaction. It is informative. N is also a meaningful input. It represents the number of shares. But P × N is not a meaningful function of those inputs.
Let’s go back to the bricks for a moment, but now suppose that the bricks are not identical. Instead, they are various shapes and sizes, and thus have different masses. Suppose that M is the mass of the brick at the top of the pile. Is M × N a meaningful function? No, because it doesn’t represent anything. There are not N units of size M. Could M × N be used as a heuristic approximation to the total mass of the bricks? Well, it might be better than a random number, but it isn’t semantically valid.
In the case of market capitalization, it is not that the shares have different prices. They don’t have prices at all. The current market price is not a property of each share, or of any share, even the last one traded. Thus, it is meaningless to multiply P by N.
Market capitalization is based on a conceptual error. People think of the price metaphorically as a physical property, such as mass. This makes P × N seem valid, because it seems like there are N objects, each of which has a quantity P associated with it, and thus P × N is the total quantity associated with the objects together. But the market price is just information, not a physical property, and it is not a property of a share.
We are used to dealing with numbers that represent physical properties. So, we tend to think of quantities in that way. This metaphor makes it easier to think, but it can be misleading.
If you believe that market capitalization is meaningful, it is probably because of that conceptual error, combined with social validation. Since it is a common error, it seems correct. There are many other examples of common errors due to fallacies. People create language games that seem meaningful because people play them.