How we measure value and why this matters

Economics and finance largely come down to how people measure the value of things. Value is always a difficult concept to pin down because it is really about what people can agree upon at a given moment in time. Money is the epitome of agreed-upon value. Dollar bills have no inherent or use value. The value of dollars or euros or yuan is determined by the consensus of buyers and sellers who will take currency in exchange for other things (exchange value). This is an enormous abstraction.

In an increasingly virtual economy, value is becoming even less concrete and more subjective. The idea that that a sequence of digits (which is what cryptocurrency comes down to) can have exchange value, just like pieces of paper (dollars) is not an enormous leap. Your bank account balance is just stored as bits of digital information rather than physical currency, so there is no physicality associated with dollars.

For something to be a viable basis for currency, it must have limited supply. The government controls the supply of currency and the computational demands of bitcoin ‘mining’ limit the production of bitcoin. Ideally, a currency will be hard to forge, too. The other attributes of a good currency (portability, durability, uniformity, acceptability) suggest that digital currency is as real as government-produced currency.

The evolving conceptualization of value has enormous implications for investing in stocks as well. When you own a stock, you own a tiny share of the value of the company that issued the stock and are entitled to a proportionate amount of the company’s earnings. This sounds like something concrete. In reality, however, you only receive a share of the earnings if the company issues a dividend. Shareholders receive earnings somewhat indirectly if the company does a share buyback. In general, though, your ownership stake is largely an abstraction. The vast majority of the value of stock is simply determined by the market’s consensus value of a share, similar to currency. While buying a share provides you with a legal claim to a portion of earnings and the firm’s assets, there is no practical way to access that value other than selling shares.

While these points might appear somewhat arcane, they are actually enormously relevant for investors. My hypothesis is that shareholders are increasingly buying stock for the fairly abstract exchange value rather than on the basis of the underlying value of a firm. Investors believe that companies will grow their earnings, so that each share is worth an increasing number of dollars. This is the primary distinction between currency and shares. The problem, however, is that earnings are also somewhat abstract accounting concepts. A company can be thriving and have very low reported earnings per share (Amazon, for example). Shareholders do not receive a direct benefit from increased earnings. Rather investors expect that the price per share will rise if the earnings per share increases or is expected to increase.

What does all of this mean for stock investors? The main implication is that measures of stock value such as price-to-earnings or price-to-book value become less useful. A currency does not necessarily need to have fundamental value and the exchange value of a currency may completely decouple from any fundamental value. A share of Microsoft, $100 dollars, or a bitcoin are, for practical purposes, entirely digital entities. While we believe that the share of Microsoft has concrete value because it represents a legal claim on a tiny piece of everything Microsoft owns, this distinction feels increasingly tenuous.