Home Forum Political Economy Signposts to Capitalization – an Early history Reply To: Signposts to Capitalization – an Early history

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Scot Griffin
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Pieter,

Thanks for your post. I am likely to have additional replies with references to sources that might have additional clues to help you fill in your timeline, which is already pretty good, but I wanted to focus this reply on the different uses of the term “capitalization” as well as how discounting is actually used in Finance compared to CasP’s simplification of it (which is fair in broad terms but leads to dismissive criticism from finance bros who encounter CasP discussions for the first time and don’t know that CasP is using a common term in a unique way).

CasP uses the term “capitalization” in a very particular and peculiar way compared to mainstream finance. Most typically, “capitalization” refers to the mix of debt and equity of a corporation, its capital structure, not its “market capitalization.” Also, investors/capitalists don’t necessarily believe the “market capitalization” (share price x no. of shares) reflects a firm’s true value, which is precisely why the Capital Asset Pricing Model (CAPM) and Discounted Cash Flow (DCF) analysis were developed to test whether or not the share price is actually at fair market value. There is no “hype” variable in CAPM or DCF analysis, for example.

The ah-hah moment for me as an executive of a publicly traded company (a role I’ve played three times but never again) is that CAPM is used to equate an investment in stock to an investment in bonds. I concluded that, as a manager of a publicly traded company, my job was to manage the company as if it were a bond of infinite duration with a yield greater than a benchmark rate. The goal was not to maximize profits in a given quarter but to simulate continuous earnings growth at a rate equal to or greater than the benchmark rate.

The simple fact is that discounting and compounding are the inverse of one another. Some of the earliest examples of the “capitalization ritual” in B&N’s 2009 CasP book relate to determining an offer to purchase a loan or bond with remaining interest payments is a fair one. A straightforward discussion of the relationship between discount rates and rates of compounding interest may be found here:

Compounding vs Discounting – All You Need to Know

A true DCF analysis of the fair value of a stock is a bit more complicated than the simple discounting formula because you have to first calculate future earnings, which is not as simple or straightforward as often discussed in CasP papers, at least for value investors who take valuation (which CasP typically equate with capitalization) seriously.

That said, CAPM is utter crap. It doesn’t work, and its authors have admitted that it doesn’t, but that doesn’t prevent 70% plus of Wall Street analysts from using the approach. CAPM has become a normative myth of Finance to perpetuate a pricing model that CasP’s “capitalization ritual” gets right in big-picture terms.

One of the things I have been working on for the CasP community is detailing a typical methodology, with excel spreadsheet templates, of how CAPM is used along with other common finance tools/approaches to yield a typical DCF fair market valuation of a stock. The goal of this project is to provide a deeper understanding of differential accumulation and differential capitalization, which to me are different but often are presented as the same thing. The power of the owners (capitalists) and the power of the firms (corporations) are different and are expressed differently.