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Supposedly the debt to equity ratio of the company and its market valuation etc give you an idea of the company's cash-flow prospects in the near future, and that is quite real

No, it's not. When Company X pulls out the razzamatazz for an IPO, and and shares climb to stratospheric levels, only to crash a year or two later, in what sense is the market valuation grounded in reality?

Especially when - as happened regularly during the Internet bubble - Company X had nothing to trade, no assets to speak of (except some cool ideas - maybe, perhaps - and a web site), and wasn't likely to start trading any time soon?

Just because it is consensual doesn't mean it's all imaginary.

Well, stock values are an entirely faith-based concept.

When someone gambles that putting $y into Company X is a good idea, all they're really saying is that they believe - for whatever reason - that at some point in the future they'll get $(y+z) back.

When markets crash, they change their minds and persuade themselves that they're more likely to get $(y-z).

So what market prices really indicate is faith in the future. Everything else, from asset valuations, to cash flow expectations, to special prices paid for shares during takeovers, depends on this faith.

When faith is absent, people won't touch companies even if they have solid asset bases, because they believe that $(y-z) is a more likely outcome. So the assets effectively become devalued. Or - in extreme cases - valueless.  

Or to take your own example - if I invest $2.5billion in Microsoft, the stock will almost certainly go up, because that $2.5billion will be seen as indicating confidence in the company.

It will either go up because people will want over the odds before they sell. (In the limit, this is how value is decided during a takeover.) Or because other people will see a pattern of sales and they (or rather their floor dealers) will decide that the stock is more valuable and should command a higher price.

If they find out that it's a bit of a punt and doesn't carry that whiff of confidence, prices will edge down again.

If they don't find out, and can be persuaded to be more confident in the stock, it becomes possible to make a nice bit on the side by pushing and pulling prices in the direction you want, with strategic buying and selling. (Lots of technical details about who files what, and who buys what, on behalf of which trusts or front companies, and whether or not this is entirely legal, have been left out here. But the principle is still valid - if you can pull it off.)

Either way you're really trading in faith, not tangibles.

Just because it is consensual doesn't mean it's all imaginary.

Is faith consensual or imaginary?

The remarkable corollary of all this is that to maximise economic growth, governments should act in ways that maximise faith in the future.

If they destroy faith in the future, sooner or later the economy will inevitably start to contract - potentially quite violently.

by ThatBritGuy (thatbritguy (at) googlemail.com) on Sun Sep 10th, 2006 at 06:29:24 PM EST
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