Signposts to Capitalization – an Early history

[Pieter de Beer]

Discounted Future Revenue: an Early History

I have found the early history of capitalization to be kind of murky. When I first read CasP four years ago, I struggled to make the connections between how we got from German logging, to the complex and sophisticated ritual of capitalization as practiced by dominant capital today.

I am not an academic, just a small-fry marketing manager for a tiny bakery in the middle east, working from home and with too much time on my hands. So I went digging for what is available online that can clarify the timeline of events.

This is what I found:

1100 – 1500 –  As a result of the gradual enclosure of the commons in Britain, the urban population swelled. The peasantry were systematically evicted from the rural lands they had been farming in communities, because landlords wanted to accumulate wealth from wool and needed the arable land for pasture. Thus the peasants needed to find work in towns and cities as a result of an end to the Open Fields system.

1272 – King Edward takes a bunch of loans at interest from Italian lenders on his way back to England from the crusades. This becomes an ongoing practice, that was likely passed on to the extension of credit within the manor. (Interest in Medieval accounts: examples
from England, 1272-1340)

1347 – The Black death and the subsequent waves of bubonic plague caused a spike in the the price of grain, and in conjunction with the reduced labour supply (because, you know, a lot of people died because they had been forced into much closer proximity with one another) resulted in a spike of real wages (Before and After the Black Death: Money, Prices, and Wages in Fourteenth-Century England). But this also resulted in abandoned land that then required labour to make it productive again. and led to a 200 year cycle of Real Estate Bubbles and booms as the wealthy attempted to acquire large swaths of arable land (The first real estate bubble? Land Prices and Rents in Medieval England c. 1300-1500) Leading in turn to schools of mathematics to then studiously work on mathematical formulae for calculating land value.

1690 – Edmond Halley collects data about the City of Breslau (in Poland) on Birth, and Age-at-Death from which he is able to produce “Life Tables” and the beginnings of Life Annuities. This is a big step in the early development in “Political Arithmatic”.
Halley’s life table (1693)

1725 – Abraham De Moivre uses Halley’s data to produce his Theory of Annuities, in which he describes the treatment of joint annuities on several lives, the inheritance of annuities, problems about the fair division of the costs of a tontine and other contracts in which both age and interest on capital are relevant. This mathematics became a standard part of all subsequent commercial applications in England.
Abraham de Moivre Formulates the Theory of Annuities

1730 – An English Land Surveyor named John Richards writes “The Gentleman’s Steward and Tenants of Manors Instructed” in which he uses De Moivre’s Theory to formulate the beginnings of Discounted Cash Flow. Which we can think of as a beta version of Capitalization. He uses his formulas to show how investments in lumber land could be compared over the lifetimes of 2 or 3 people, in terms of overall revenues, so that investment in the land could be sold at present discounted value.
The Gentlemans Steward and Tenants of Manor’s Instructed

1801 – John Buddle Jr., a Coal Mining Engineer in England, popularizes the use of DCF to predict future profits of coal mines. Before 1801, the practice was very rare, and only one or two instances can be found in the records, but after 1801, the practice becomes very popular and gains wide-spread use.
The Emergence of Discounted Cash Flow Analysis in the Tyneside Coal Industry

1805 – 1820 Mathematicians in Germany and Italy (Nordlinger, Hossfeld, Gioja) write more advanced versions of DCF. But these remain mere formulations, and do not yet constitute developed political economy theories.
Journal of Forest Economics 12 (2006)

1849 – German Forest Scientist Martin Faustmann develops Faustmann’s Theorem, which tells forest owners the exact time they need to cut down their forests for lumber based on DCF formulations.
Faustmann’s Formulas for Forests

1877 – DCF finds it’s way across the Atlantic when Arthur Mellar Wellington, a railroad locating engineer wrote the Economic Theory of the Location of Railroads, so that Railroad Companies could have a more sophisticated method for evaluating Capital investments.
The Development of Discounted Cash Flow Techniques in US Industry

1904 – John Raskob and Pierre Du Pont develop their Return on Investment model for Du Pont. This significantly reduced the cost of managing complex integrated firms and the cost of discovering new profitable investments within the firm.

1914 – Walter Pennel an engineer at Southwestern Bell shows that the SouthWestern Bell’s Present Worth Studies are superior to other Present Value Studies done by utilities, railroads, and mining operations, because they take other policy and intangibles into consideration.

1921 – Convergence starts gaining momentum as Donaldson Brown of General Motors, who assisted Du Pont in developing their ROI model, starts using Divisional ROI Forecasts. This lets top executives centrally control how their managers deploy resources in different divisions of the firm.

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Now as I stated before, I am not an academic, and have no real understanding of research methodology, and limited access to resources. I am hoping the various points in this timeline can be fleshed out by people with better understanding of the source material and the requisite academic methodologies.

 

Topic

[Blair Fix]

Thanks for this research, Pieter. You’ve uncovered some important landmarks for how the practice of discounting evolved.

There is no better training for doing research than simple doing it. Sure, you’ll make mistakes (visible in hindsight). But that’s science. I hope you share more research in the future.

[Pieter de Beer]

Thanks for the encouragement Blair.

I think I will Flesh this piece out in full depth before I move on to any other subjects within the CasP sphere, I have found it deeply fascinating digging this information up over the last few weeks, and in looking over the sources, there is a lot to do in connecting the dots to show this evolution from feudalism to mercantilism, to proto-capitalism.

I’m not happy, for instance with the limited view of focusing only on England and the USA, and am sure that if I broaden the horizons, there would be far more informative information surrounding the rest of Europe, the Middle-East, the Far East, North Asia, Africa, and south America.

I also don’t think that the level of detail here is even remotely granular enough, and so the “intuitive leaps” needed to jump from event to event might actually be completely incorrect.

[Scot Griffin]

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.

[Pieter de Beer]

This is an invaluable response already, thanks Scot.

I can definitely see how, given the CasP framework of encompassing political influence into the notion of capital, straight forward  market cap would not be reflective of power. And I can also understand that CAPM falls short because it would necessarily need to exclude specific kinds of social relations, and “external influences”.
Finance has always, in my view, been an attempt to quantitatively assess a fundamentally qualitative field of social ecology, and the subjective aspects of this social ecology will not be representable in an accurate, or meaningful quantitative measure without including arbitrary classifications that must limit the scope of the valuation. As a result, the subjective “God-of-the-gaps” is filled in with pseudo-empiricism that either over-inflates firm value, or vastly under-estimates aspects of the social ecology, or both.

I’m passingly familiar with CAPM, and a few other Valuation methodologies, predominantly because I spent some time a few years back ruminating on and searching for various theories of value. I have my own ideas about what may or may not work as a value theory in reality, but am able to admit I don’t know nearly enough about the way the world (dis)functions to be able to put my ideas into a coherent theoretical framework just yet. (The best and closest description I have encountered so far is Ryan Salisbury’s Priority Theory of Value and his proposed system of Transferics which I believe has fallen dormant for a while now, due to a lack of critical feedback )

In my original post I chose not to look past 1921 into the origin of Discounted Present Value, specifically because it gets very complicated, very fast. The Great Depression, the circumstances leading up to it, and its subsequent results within the world of finance, are extremely complex (and become ridiculously convoluted over time), and there is such a vast amount of literature, that it is more than daunting to someone who has not actually studied the field, let alone worked within it.
Hence my objective is to look at where it all started (for the contemporary system anyway) so that I can see how foundational principles evolved into what is used in practice today.

I think once I have a clearer understanding of the origins and evolution up to the point of the Great Depression, I might be ready to do a deep dive into the 90 years since then.

• This reply was modified 2 years, 11 months ago by Pieter de Beer.

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