Because ‘basic corporate finance’

On the Today show, this morning, I saw Savannah interviewing Rep. Paul Ryan about the tax bill.

She pushed hard on the cut in corporate tax rate in the plan.

His response was valid.

We have the highest corporate tax rate in the industrialized world. It will be good for the economy to be more competitive, so companies stay here and invest more here.

She pushed again…but Michael Bloomberg, CEO of a large company, says he won’t invest more here. He’ll buy back more stock.

Ryan’s response was valid. That’s one anecdote against studies that show otherwise.

But I think he missed a golden opportunity.

Here’s what my response would have been:

It’s great that Bloomberg supports our position.

I envision Guthrie getting confused look at this point and responding with, But he said he would not invest more. How does that support your position?

He said he’d buy back stock. Basic corporate finance tells us that stock buybacks is one way to return money to owners. Paying dividends is the other. Ask any first year B-school student.

What do investors do with money they receive from their investments?

Often, they invest it elsewhere. 

While Bloomberg’s company might not have good projects to invest in (which may be a problem for Bloomberg), other companies might.

With more money in their pockets, the folks who sold shares to Bloomberg will be able to invest more in companies that have better investment prospects, like Google or Facebook or start-ups building better solar panels, curing cancer or the company that might disrupt Bloomberg’s own business model.

So, the economy still gets the benefit of the reduced corporate tax rate, even if companies, like Bloomberg’s, don’t directly invest their extra cash. Others will be more than happy to.

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Don’t encourage the un-encouragable

Alex Tabarrok of Marginal Revolution shares his favorite of Morgan Housel’s Motley Fool article, 122 Things Everyone Should Know About Investing And The Economy.

I especially agree with this one:

For many, a house is a large liability masquerading as a safe asset.

This is important to understand and relates to my previous post.

In the U.S. we (especially politicians) have rose-colored glasses when it comes to home ownership. We think it’s good, always. We think, the more the better, always. We have this same affliction with education.

So, you start to see politicians do things to make it easier to become a home owner, like lowering down payment standards.

Home ownership can be good, but as with all good things, it isn’t good for every situation. And, there is a law of diminishing returns that limits the more is better, always.

Back in 2010, the Wall Street Journal interviewed Canada’s Finance Minister, Jim Flaherty. I wrote about that here. Canada did not have a banking crisis in 2008. Part of the reason why is that they do not see home ownership with rose-colored glasses like we do. This prevents them from doing unwise things like getting people into home ownership when renting is likely the best option for them.

He said:

“They [Canada’s version of Fannie and Freddie] are supposed to have a certain part of the market but they are not supposed to be a dominant player in the market. They do make sure that lower income earners have access to a roof over their heads, but that can mean rental housing.

There’s no stigma to renting there. That kept Canada’s government, mortgage lenders and borrowers from doing things that encouraged risky home ownership.

In the interview, Flaherty points out some of these things

  • Canada’s lenders didn’t securitize (sell off) mortgages, or off load risks of bad mortgages, to others. They lent and held the mortgage, so it was in their best interest to make good loans.
  • Borrowers couldn’t just walk away from a home with a mortgage. “They remained personally liable.” That encourages borrowers to be more prudent about becoming a home owner. If you can’t rid yourself of the debt by simply stopping paying your mortgage and walking way from the house if things go south, then maybe you don’t buy a home or you buy one that better fits your budget.
  • Canada’s tax code also doesn’t treat mortgage interest as a deduction. This policy also tips the scales toward home ownership in the U.S.

Small businesses are dead capital

Often, when I’m reading a Forbes article and I think to myself, “This is a darned fine article,” I look at the byline to find it is another good article by Daniel Fisher.

That happened recently while reading, How the Government is Helping Hedge Funds Make Billions off IPOs.  This paragraph caused me to glance at the byline:

Hedge fund managers can thank Congress and the SEC for the opportunity [to buy early stakes in companies before they go public]. Some call it “regulatory arbitrage”: well-meaning but inherently flawed laws such as Sarbanes-Oxley that were designed to protect small investors from the next Enron have imposed such heavy costs on public companies that many private ones are delaying their initial public offerings. Venture capitalists, employees and early investors who want to sell out have little choice but to sell their shares to lightly regulated funds, which can buy stock in the next IPO at a steep discount to what retail investors ultimately will pay.

Innovation has a lot of headwinds these days. Most of it caused by (to borrow Fisher’s words) ‘well-meaning but inherently flawed’ ideas.

But I find the well-meaning and inherently flawed ideas around investing in small businesses especially annoying.

In this country you can easily sign up for an online brokerage account and buy and sell slivers of ownership in thousands of publicly traded companies on the various stock exchanges for as little as $4 per trade, with some assurance that the presence of the Securities and Exchange Commission has lowered your chances of being defrauded.

You can just as easily make personal loans to people who need cash now using Prosper.com.

You can donate money to loan to small businesses and create jobs (and make money). Well, at least you get a bracelet with that one.  Or you can lend money to entrepreneurs all over the world. You can also donate to individuals who need help funding the creative projects like a large tortoise that looks like a trading post.

But, if you want to invest with entrepreneurs here at home, it’s not so easy. You need to know somebody who wants to start a business. Or know someone who knows someone. Or you need to know a venture capitalist. Start-up investing is an opaque network of angel investors and venture capitalists.

This, folks will tell you, is for our own protection because there will be too many con men out to get you to invest in their bogus company.

But, I’d rather make it easier for everyone to invest in start-ups and let the market develop solutions to help people from being defrauded. The SEC currently makes trading equity in unregistered companies very difficult. This basically makes small businesses dead capital.

Prosper.com and Kiva.org use simple approaches to limit your risk.  First, you lend in small amounts to individual borrowers — for example, $25 — and you can diversify across many borrowers. So, if you lend to one deadbeat who doesn’t repay you, you’re not out your life savings.

Second, these sites act as an SEC and rating agency of sorts by qualifying borrowers and setting appropriate interest rates based on credit risk. Kiva.org works with organizations that administer the loans with the entrepreneurs with full disclosure on that organization’s track record.

We could use the Prosper/Kiva/Kickstarter models bring start-up and small business capital alive. A similar service could act as registration agent of sorts and market maker to connect investors and business owners and allow users to invest as little as $5 directly with entrepreneurs.

Why not? I’d rather invest directly in an entrepreneur with a chance, even if it is ever so slight, of getting a return on that investment than donate it with the assurance that I won’t.

“We owe it to ourselves”

Economists/bloggers have been having an Internet debate over whether government debt has any true impact on an economy.

I know to us laypeople that sounds kind of crazy.  Of course it would.  But, us laypeople also give a lot of rope to economists — especially ones who have been adorned with Nobel prizes and write columns in newspapers — assuming they know their stuff, so I thought the topic might be worth addressing and might further my understanding of the topic as well.

Unfortunately, I don’t feel like many of the economists have done a good job of making the debate palatable for the general public.

I’ll try to lay it out the two key positions, as best as I understand, and would love to know if I got any of this wrong.

Position 1:  Government debt has no impact on the economy.  Since the government debt is borrowed from citizens (much of it, at least) and paid back by citizens, then it really “costs” nothing because we owe it to ourselves.

Position 2:  Government debt does create a burden, but it’s not what us rube laypeople think.  It’s not the debt that’s the burden.  Rather, it’s our reaction to the debt.  Because I know that my grandkids will have to pay back this debt, I save a more to pass on to them. That additional savings now is the true burden (which I think is actually equivalent to what us laypeople think too, but I’ll leave that one alone for now).

Here’s my take and I’d love to hear what I’m missing, because I’ll admit that I’m sure I’m missing something.

I believe Position 1 is wrong because it has one key flaw.  It’s the word “ourselves.”  What’s wrong with this line of thinking is what’s wrong with the field of macroeconomics, in general.

“Ourselves” is fiction.  It’s an aggregate, or sum, that means nothing.  Add up mine and Bill Gates’ wealth and you’ll find that our average wealth per person is around $20 billion.  The problem is that $20 billion exists nowhere in our reality.  I don’t have anywhere close to that wealth and Gates has all of it.  So, saying that Bill and I have $20 billion on average means nothing.

Let’s give a closer look to the fiction in Position #1.  I get a loan from Joe and force you to pay him back.  In macroeconomics, I would lump me, you and Joe, together and try to make you feel better about saddling you with the debt by telling you “We owe it to ourselves, so in net, we‘re not worse off.”

The only problem is that “in net” doesn’t exist anywhere except in my head.

You obviously are not better off.

Even if I did something spectacular with Joe’s loan that somehow benefited you, that doesn’t mean that Joe couldn’t have done something just as spectacular if he hadn’t loaned it to me.

So, what am I missing?

I’ve been working on this draft for a while.  I came across Don Boudreaux’s column on the subject and found that he makes the same argument here, which makes me feel  better that I’m on the right track.

I’d love to hear if I am missing something.  But, please do not use any examples that includes pizza deliveries from the future.

Lemonade Stand Economics

Thanks to Russ Robert of Cafe Hayek for pointing me to Jerry Jordan’s Investors Business Daily article,  Government Accounting is Like Lemonade Stand Economics.

I attempted to explain the same topic that Jordan writes about last September in my post, Government is an expense.

My key point then was that GDP is often misused as a measure of health for the economy, but that is like measuring the health of a business by adding its revenues and expenses together.

Jordan explains it better than I did with a lemonade stand example.  In his example, kids invest $10 in a lemonade stand, make $7 back by selling cups of lemonade and folks think that is good because there was $17 worth of economic activity, instead realizing there was a $3 loss.

GDP is not a good measure of the health of the economy because it’s like considering the $17 of lemonade stand spending and saying that was good, rather than realizing that $3 of value was lost in the process.  None of us would last long if we kept turning $10 into $7.  But, that’s essentially what we do when we increase government spending to keep GDP up.

The lemonade stand kids should learn from the signal they received from the market.  The signal is that selling lemonade in the neighborhood is not worth their while because customers do not value a glass of lemonade in that time and place to pay enough for it.

So, the kids should try other things.  Maybe they should try a different drink or different corner.  Or maybe they should offer to do yard work for their neighbors.

They should keep experimenting to discover things that their neighbors do find worthwhile enough to pay enough to make it worth the kids’ while too.  Full disclosure, I tried the lemonade stand experiment a few times too.  I tried it in the street and at family garage sales.  It never produced profits for me.  I did much better doing things like mowing lawns, raking leaves, shoveling snow and assembling bicycles.

We do no good encouraging the kids to keep at turning $10 into $7 to maintain that $17 of economic activity.

Incentives matter

Yesterday, the Wall Street Journal reported that public schools are charging kids and parents fees to help make up for budget shortfalls.  Various school districts are charging fees for a variety of things including registration, technology, special activities like cross-country, and even graduation.

A family featured in the article paid over $4,400 to the public schools, in addition to $2,700 in property taxes that goes to fund education.

One photo caption in the article explains that a student had to choose band over choir because of the fees.  Another student chose track over cross-country because of fees.

The mother of band member lamented:

It’s high school. You’re supposed to be able to try different things and see what you like.

I understand.  That is certainly the model of public education we grew up with.  But, that’s part of the problem.

We’ve funded education through the third-party taxpayer dollars for so long that looking at the costs now makes us uneasy.  Several generations of parents have been able to send their kids to public schools and let their kids take full advantage of what is offered without having to consider the cost we incur on taxpayers.

We’re not used to making the full economic evaluation — the price/value decision — that we make for many other goods.  We have grown accustomed to getting about $11,000 per year per child per year of education for what appears to be free (I doubt many people even know the cost per pupil of their local public schools).

That’s not a tough choice to make.  Most people will accept $11,000 of “free”* stuff (*no incremental cost to the user).  Many people will even accept it if that $11,000 worth of public schools is only worth the equivalent of $4,000 of private schools.

Free is free, right?  Few people would turn down a free car (paid for by others) that cost $30,000 to build, even if a very similar car was available for $20,000 to buy.

If other people didn’t pay for the $30,000 car, the company that builds it could not  compete with the company that makes the $20,000 car.

While I sympathize with the mother’s lament because the education model appears to be changing from an open bar to more of a cash bar, I think it’s a good thing.

It might cause parents and kids accept the full economic evaluation.  Things that provide marginal value to students might go away or go into the private market.

To parse the mother’s statement, while high school became a place to try new things over the last few decades, I’m not sure that’s the proper role for it.  High school should be a place where kids learn things.  Life is where we try new things.

Finance 101

I’m dumbfounded by business leaders who don’t understand what drives the value of their companies and disappointed when this lack of understanding ends up causing them to make decisions that destroy value.

The stock price is the present value of expected future cash flows, per share.

Most middle or high school students are capable to do the math needed to value a stock after learning how to calculate the time value of money and compound interest.

Let’s use GE as an example.

Based on Google Finance, GE’s earnings (per share) last year was $1.19.  That’s down from from $1.78 two years ago, a drop of about 15% per year.

The following is an example of simple spreadsheet I use help me value GE’s stock.

I won’t describe in detail the math.  I just included it to illustrate that it’s pretty simple.  Though some of my assumptions could probably bear some explanation.  Perhaps I will cover in more detail in a later post.

The key point here, is with a few assumptions and some 8th grade math (maybe 6th grade these days) I was able to get a reasonable estimate of the stock value.  This should be a basic expectation for a business leader.  Unfortunately, it’s not.

If you have business leaders that could use a refresher on basic finance so they can drive to the right results, let me know.