Size Matters. But Define “Size”.

March 9, 2012

The logo of the former largest company in the world, the East India Company. Graphic design was not a priority in the 18th century.

 

Quick, what’s the biggest company in the world?

If you’re a casual reader of the business news, or were last summer, you might say “Apple”. It was something of a noteworthy deal when Apple moved into the top spot, but what does that top spot signify? Does it mean that Apple sold its products for more money than anyone else did? That its owners got richer than anyone else did? That its owners would get richer than anyone else, if they liquidated their interest? Or something else? Are we thinking too hard about this?

Yes. The biggest company in the world is the one that generates the most revenue.
Isn’t it?

Sure, but what if there’s another company that generates slightly less revenue, but has significantly smaller expenses and thus keeps more of the revenue as profit?

Uh…yeah, you’re right. That’d make more sense. 

But isn’t value in the eye of the beholder? Say there was a company that took in even less revenue, and didn’t necessarily turn a stupendous profit. But, investors loved the company so much that they valued its stock highly. And if you wanted to buy this entire company, share by share, you’d have to spend more than you would to buy any other company.

Okay, you sold me. That should be the definition of the world’s largest company. There can’t be any other ways to interpret this, can there? 

CAN THERE? 

Well, how do you determine your own net worth? You add the assets and subtract the liabilities. Do the same thing on a macro scale and you have a company’s shareholders’ equity, which should be the definitive, absolute, certain way to determine a company’s magnitude. Aside from the other ways we just mentioned.

Okay, time for the real-world results.

REVENUE: The company that takes in the most money is Walmart. Last year, that meant $421 billion.

Walmart makes money on volume, not margins. Anything you buy at Walmart, Walmart bought for only a little bit less. Walmart doesn’t turn big profits on any individual item – the Birkin bag that the retailer buys for $45 and then turns around and sells to you for $20,000 isn’t on the shelves at Walmart. But the nickels and dimes that Walmart makes on every grocery item and article of inexpensive clothing keep its profits huge and its shareholders happy.

Which means Walmart spends tons on what it buys. It turns a profit, and a substantial one, but not as big as at least one other company’s.

PROFIT: Apple made $26 billion last year, despite selling a lot less than Walmart. How? Because while Apple sells less than Walmart, the profit on each item Apple sells is far, far greater than on what Walmart sells.

Last year somebody estimated that it costs Apple about $180 to make each iPhone. Meanwhile, new unlocked 4S models with 64GB of storage sell for over $800 on eBay. It’s hard to imagine a single product that Walmart makes a $620 profit on. Except the iPhones.

For the record, when Apple was announced as the largest company in the world in the summer of 2011 (or more to the point, when news of its financials trickled down from the business news departments to their knuckle-dragging counterparts on the general news desk), it wasn’t because of Apple’s profits. It was because of another metric.

MARKET CAP(ITALIZATION): Apple had the largest market cap in the world for a few weeks earlier this year, but ExxonMobil then caught up and regained its place on top. As of this writing, Apple has wrested the title away yet again. Right now, if you wanted to buy every share of AAPL it’d cost you $480 billion. That’s about ⅙ more than ExxonMobil.

Which leaves one remaining measure.

EQUITY: The company with the biggest difference between its assets and its liabilities is Bank of America, whose shareholders’ equity sits at around $228 billion.

Most of the top companies in shareholders’ equity are banks (both commercial and investment) and insurance companies. A major chunk of their assets come in the form of loans. What you and we sweat over, banks get excited by. Loans are their stock in trade, which sounds like an obvious point but is easy to forget sometimes.

How does this apply to your daily life? Well, to the extent that it forces you to think of multiple valid ways to look at the same problem. Who’s in a better place – the person who makes $150,000 a year, or the one who makes $120,000 and clears $60,000 after expenses while the first person spends every penny and then some? It’s a legitimate question, not a rhetorical one. And once you’ve determined an answer, how does that person stack up against someone who makes $70,000, but has a net worth of $5 million?

More money is better than less: if you don’t agree with that, you probably shouldn’t be reading our blog. But there are multiple ways to determine who’s in the most enviable financial position.

This article is featured in:

**Carnival of Financial Camaraderie #26**

Filed Under: Education, Investments, Math, Net Worth Tagged With: , , , ,

DOW HITS 7634! What now?

February 24, 2012

The father of irrational exuberance. If Bush had just yanked his hands down, a lot of problems could have been avoided

 

Huge, breaking, earth-shattering, paradigm-shifting, cliché-inspiring news this week, as the Dow Jones Industrial Average finally pawed its way back over the critical 7634 mark. No longer will we have to suffer in a world where the sum of the prices of 30 blue-chip stocks multiplied by a constant will begin with 7-6-2 or some lesser string of digits. Instead, let’s all stop at this milestone and take a needed respite.

Oh, sorry. Yeah, we were using base-12. Would you prefer we used base-10? Fine, but we’re going to use a different currency, euros. Which would make the Dow level 9807. No wait – let’s use base-12 and euros. That’d make the Dow level 5813. Isn’t this fun?

Most of the stock market “news” results from humans having 5 fingers on each hand and needing a way to count things. There isn’t any appreciable difference between a Dow at 12,999 and a Dow at 13,000, except that the latter burns a different array of bulbs in a digital readout and gives mathematically challenged journalists a chance to write headline fodder. Stop believing that this is in any way important.

From our favorite purveyors of loaded rhetoric, the Associated Press:

The Dow passed 13,000 about two hours into the trading day.

And from another AP story:

The average was above 13,000 for about 30 seconds before dropping back. It reclaimed the mark just after noon.

In the words of Anti-Nowhere League, “So (expletive) what?” They’re talking about this like it’s the moon landing, calibrating the event by time and duration so future generations will have a historical record of it.

Furthermore, the mere addition of one point to the Dow then becomes the catalyst for everything that follows. One more AP story, and a stunning example of why reading the news with a trusting eye is worse than not reading it at all:

The 13,000 level is a psychological milepost, but in a market built on perception, it could influence more cautious investors to pump more money back into the stock market, analysts said.

“You need notches along the way to measure things, and that’s as good as any,” said John Manley, chief equity strategist for Wells Fargo’s funds group…

Dan McMahon, director of equity trading at Raymond James, called the 13,000 marker a “positive catalyst, and that’s what we need to get us through the next range.”

Sounds like these Wall Street guys are as susceptible to “decimal bias” as the rest of us, right? No. McMahon continues:

In the end, he said, it’s just “a big round number.”

Which shows that the claims that “analysts said…it could influence more cautious investors to pump more money back into the stock market” is an unmitigated lie. Or if not a lie, then at least an unprovable assumption. Sure, Dow 13000 “might” influence investors to buy stocks. It also “might” turn the milk in your fridge sour. You don’t think so? Then show why it can’t.

CBS News has a video clip with the wonderfully objective title: “Dow 13,000: Time to Invest?”, which itself summarizes why financial illiteracy is pandemic. Yes, first let’s overpublicize a rise, however modest, in the Dow level. Then, let’s imply that people should buy stocks. Because that’s when you want to buy, when prices are rising.

You want superlatives? The Dow is now at its highest level since May 2008. When the Dow was at 12,990, that was its highest level since…May of 2008. Add the inexorable effects of inflation, however modest, not to mention whatever fees you paid for your index fund, and if you’d bought before May of 2008 you’d still be behind. If, however, you were dollar-cost averaging and buying units regularly since then, including when the market hit a local nadir of 6627 in March 2009, you’d be ahead. The Dow’s most recent movements, i.e. what it’s done in the past week, mean nothing.

We’ve talked early and often about the need to handle your financial transactions in a cold, calculating manner. Save the emotion and the irrationality for your personal, non-monetary life. When everyone else is chasing something, step back and ask why. When everyone else is fleeing something, same thing. And when a numerical quirk becomes front-page news, bumping Iranian oil embargoes to the second line, think about what that really means. To the extent that it means anything.

Yet another reason why our use of exclamation points on this site is so judicious. If a bunch of talking empty heads filling time in a TV studio have somehow convinced you that a .06% rise in the Dow is a reason to get your money out of your beer fund and put it towards stocks, we can’t help you. Besides, you don’t want to be helped.

There’s a time to get going, and a time to sit back (apologies to St. Francis.) If you don’t have an investment plan yet, run to the nearest brokerage house, bank, or human resources office and get one. It’s never too early to start.

But once you’ve invested, which we’re presuming you have, don’t drown in the details. Try to look at your portfolio quarterly. That recommendation is like Tolstoy’s challenge to not think of a white bear, but if you can do it, you’ll not only have greater peace of mind, you’ll be able to notice measurable differences in your portfolio more easily. It’s the same reason why parents marvel at how quickly their nieces and nephews grow, rather than how quickly their own kids do.

Getting excited, depressed, or even having an opinion about Dow 13,000 is mayfly syndrome. But you’re a human, with a lifespan tens of thousands of times longer than your typical mayfly. Even a giant daily swing in the Dow is utterly irrelevant, let alone one of just a few points.

This article is pick of the week in:

**Top Personal Finance Posts of the Week-Cutest Kids Ever Edition**

Filed Under: Capitalism, Economics, Education, Math, Newsflash Tagged With: , , ,

We Learn Nothing

January 13, 2012

We’re going to need more chairs

 

Not that many years ago, real estate was regarded as a safe investment. Now it’s the butt of jokes. What happened?

Fannie Mae (formerly the Federal National Mortgage Association) is one of the government-sponsored enterprises entrusted with making it easier for people to afford homes. Its sibling, Freddie Mac (né Federal Home Loan Mortgage Corporation), is another. A cousin, Ginnie Mae (Government National Mortgage Association) does pretty much the same thing, the big difference being that Ginnie Mae doesn’t pretend to be a private company.

One-paragraph summary:

You borrow money from ABC Bank to buy a house. Now you have a house, and ABC has your promise that you’ll pay them, say, $250,000 (with interest) over the next 30 years.

(On second thought, there’s no way in hell we can do this in one paragraph.)

That promise, from ABC’s perspective, is an asset. Of course it is, it’s money coming in. An annuity, if you will. ABC can then sell that asset to a secondary lender (ABC is the primary lender, duh) such as Fannie Mae.

ABC now has cash from Fannie Mae, cash that ABC can loan out. Loaning out money is the very purpose for a bank’s existence, thus ABC is happy with this situation. If ABC loans that money out to someone else for a mortgage, then if all goes according to plan, now you and that other person will own houses, instead of just you.

Fannie Mae was founded by the federal government in the 1930s, under the principle that having as many people as possible owning houses (and, by extension, owing banks money) was a goal worth pursuing. The logic went that with more liquidity – i.e., more money to be loaned out – not only would more people be able to afford homes, but mortgage interest rates should lower, too. A self-perpetuating cycle of easy loans for everyone!

I don’t understand what Fannie Mae is getting out of this. Wouldn’t they have to pay a premium to ABC for the transaction to be worth ABC’s while?

Yes. Fannie Mae pays the bank a ¼% servicing fee for the life of the loan.

Oh, I see. So Fannie Mae loses money on every loan. Sounds like a great way to do business.

Fannie Mae gets to borrow from the U.S. Treasury at extremely favorable rates. Currently ¾%. So with the average 30-year mortgage going for about 3.96%, Fannie Mae comes out way ahead.

So it’s the U.S. Treasury that’s losing money on every loan.

Yes! Isn’t “capitalism” great?

Now, Fannie Mae doesn’t just hold onto that money. It assembles your $250,000, your neighbor’s $281,384.34, and several other mortgagors’ loans into a multimillion-dollar mortgage-backed security. Then it sells that mortgage-backed security to an underwriter. The underwriter pays a higher interest rate to Fannie Mae than the ¾% at which Fannie Mae borrows from the U.S. Treasury, so Fannie Mae is happy. The underwriter is happy, because it has cash on hand (again, to loan out) and is paying a fairly favorable interest rate. But that rate is artificially low, because it’s based on the artificially low rate that Fannie Mae borrows from the U.S. Treasury at.

Isn’t this creating money out of thin air?

It’s creating “liquidity” out of thin air, which is almost the same thing.

With the creation of Fannie Mae and its relatives, the federal government effectively lowered the requirements for a prospective homeowner to get a mortgage. To the point where people who weren’t yet ready to own houses were owning houses. Some of whom were never going to be able to pay their mortgages back, and who got foreclosed upon.

Well, couldn’t lenders just charge those people sufficiently high interest rates that it’d be worth the increased risk to lend to them?

Of course not, this is America.

In the ‘90s, the government ordered Fannie Mae to keep a minimum percentage of its loans in mortgages for “low- and moderate-income” borrowers. By 2007, fully 55% of Fannie Mae’s loan originations were with such borrowers. The government then prohibited Fannie Mae – which is to say, the primary lenders who sold loans to Fannie Mae – from charging “predatory” rates.

So lenders were left with two choices: continue doing business with Fannie Mae, and risk losing money on bad clients; or don’t do business with Fannie Mae, and set their own high rates for borrowers with poor credit histories who didn’t deserve to borrow money at prime rates (the infamous “subprime market”.)

If lenders went with option B, they could create their own mortgage-backed securities, with higher interest rates and higher volatility. Those privately fostered mortgage-backed securities then hit the market, at which point people stopped buying Fannie Mae’s mortgage-backed securities (at their comparatively low interest rates.)

So Fannie Mae started offering higher, more competitive interest rates. The free market at work, right?

Sure, except Fannie Mae and Freddie Mac only pretend to be private corporations with stockholders and everything. The federal government goes to great lengths to explain that Fannie and Freddie are not branches of itself. Functionaries can quote you the 1968 act that led to Fannie Mae being named an “independent” company. In reality, the government wanted to remove Fannie Mae’s obscene levels of debt off the national balance sheet (cf. Abraham Lincoln, a tail ≠ a leg). Investors and customers alike continue to treat Fannie Mae as a branch of the government, with an implicit government guarantee if not an explicit one. Put it this way: if your elected representatives committed billions of dollars of your tax money to AIG, General Motors and Chrysler, they’ll do it for Fannie and Freddie. Again.

Which would you rather invest in, assuming each had the same credit rating: private or Fannie Mae mortgage-backed securities?

The latter offered returns similar to the former, only with that implicit guarantee. Therefore people bought more of them. To create more mortgage-backed securities, Fannie Mae made more and more low-interest, sketchily underwritten loans. A private bank like Lehman Brothers can die a quick death and leave the remaining banks healthier. But there’s no concept of culling the herd when it comes to Fannie Mae.

(There is nothing government can’t ruin. Vote Ron Paul.)

Meanwhile, because of the low mortgage rates Fannie Mae was responsible for spawning in the first place, millions more people bought houses than otherwise would have. Too many people chasing too few houses means prices rose. A “bubble”, if you will. Then borrowers started defaulting, and lenders realized that they didn’t have enough collateral to cover debts.

When there’s downward pressure on primary mortgage loans, and upward pressure on secondary mortgage loans, something has to give. Add to that the underqualified people who couldn’t make their mortgage payments, and thus got foreclosed on, and the result was even more houses sitting empty. By 2008:

  • Fannie Mae and Freddie Mac either owned or guaranteed half the residential mortgages in the country.
  • As “independent businesses”, “free of governmental control”, and publicly traded, their stocks began to drop. In the case of Fannie Mae, 99.66%:

 

It’s almost impossible to lose a higher percentage than that, yet Freddie Mac managed:

 

 

  • As investments, Fannie Mae and Freddie Mac were effectively worthless.
  • The Secretary of the Treasury, operating under the orders of his boss, lied through his teeth and told the public that Fannie Mae and Freddie Mac were financially sound. No one who’d examined the issue could possibly believe this, but the public at large might have.
  • Someone owned Fannie Mae’s and Freddie Mac’s mortgage-backed securities. Actually, lots of people. Foreign governments, retirees’ pension funds, etc. The argument went that if Fannie Mae and Freddie Mac were officially deemed worthless, disaster would occur. As if requiring half a trillion dollars from American taxpayers didn’t qualify as a disaster.

So the federal government did exactly that, putting you on the hook for every horrible decision made by entities that created no value in the first place, and distorted the market by their very existence. It would have been less damaging to have simply cut a five-digit check to each family that wanted a house and didn’t have the money for it.

Fannie Mae and Freddie Mac aren’t subject to the same capital and diversification requirements that private banks are. Nor do Fannie and Freddie ever have to worry about having their loan portfolios reviewed by regulators, nor rely on those same regulators to give them a safety and soundness rating.  

Today, Fannie and Freddie continue to have a hand in most residential mortgages. They still lose staggering amounts of money – $14 billion and $22 billion last year, respectively. And as we’ve seen, their stocks now trade on the over-the-counter bulletin board, the Canadian Football League of securities trading.

Fannie Mae’s chairman made $6 million (of your money) last year, Freddie Mac’s $4 million. Yet none of those Occupy Wall Street vermin protested outside their respective headquarters. Merry Freaking Christmas.

This article is featured in:

**Top Personal Finance Posts of the Week: Apple is Kicking Google’s Tail Edition**

**Totally Money Carnival #51**

Filed Under: Bad Examples, Consumer Debt, Economy, Education, Newsflash
« Previous Page
Next Page »