In business, plenty of things are subjective: culture, leadership, innovation.
A good culture to you might be a bad one to me. A capable leader to you might be an asshole to me. An innovative solution to you might be an incremental tweak to me.
But the stuff that really matters…that stuff is objective, right? We can all agree the company’s total revenue, and what its operating costs were. We can compute its return on invested capital. We can study its cash balance, and describe its financial performance relative to its peers.
Businesses are meant to make money, and money is something we can easily measure. It’s the bedrock beneath our conversations about light and fluffy stuff that can’t be measured. (Though Douglas Hubbard would disagree that soft things like leadership and innovation aren’t measurable.)
The problem is, even when we measure something in dollars and cents, our results aren’t objective. Let’s explore this a bit.
An expert opinion from Ludwig von Mises
Ludwig von Mises was born in Austria-Hungary in 1881. He became one of the most important advocates of the Austrian School of economics. The Austrian school is built around the importance of the actions of individuals. And one of the most important decisions an individual makes is how to spend her money.
Here’s what von Mises writes on page 39 of one of his books, The Theory of Money and Credit:
But subjective valuation, which is the pivot of all economic activity, only arranges commodities in order of their significance; it does not measure this significance. And economic activity has no other basis than the value-scales thus constructed by individuals. An exchange will take place when two commodity units are placed in a different order on the value-scales of two different persons. In a market, exchanges will continue until it is no longer possible for reciprocal surrender of commodities by any two individuals to result in their each acquiring commodities that stand higher on their value-scales than those surrendered.
Further, he writes on page 131:
The process, by which supply and demand are accommodated to one another until a position of equilibrium is established and both are brought into quantitative and qualitative coincidence, is the higgling of the market. But supply and demand are only the links in a chain of phenomena, one end of which has this visible manifestation in the market, while the other is anchored deep in the human mind. The intensity with which supply and demand are expressed, and consequently the level of the exchange-ratio at which both coincide, depends on the subjective valuations of individuals.
That last line is crucial. Prices, or what von Mises calls exchange-ratios, are a manifestation of the subjective valuations of individuals. What does that mean? Let’s use an example.
My own personal example of value-scales at work
I recently bought an Amazon Fire TV. It’s a set top box that connects to my television. I use it mostly for watching movies.
Why did I choose it? Because my wife and I have moved our movie collection from disc to digital. We buy all of our movies now from Amazon. So the Fire TV is the easiest way for us to watch our movies. And it cost $90, which was reasonable given the use we get out of it. Done.
What can I infer about my own personal value-scale, in the words of von Mises? I valued the Fire TV more than the Apple TV. The Fire TV is less expensive, and the Apple TV, at least for the moment, won’t play our Amazon movies. I valued the Fire TV more than a Roku, or any other set top box, because it works well with our movies, and its voice interface is really nice. Plus, we already have an Echo, so having our devices integrate nicely is another plus.
But my value-scale goes way beyond comparing between set top boxes. I didn’t have to spend $90 on a new set top box. I could have continued using the same setup we had before. I could have just saved the $90, or spent it on a new wristwatch, or a pair of shoes, or home office supplies, or anything else.
My value-scale led me to the decision I made. I steered that money toward an Amazon Fire TV, even though there were countless other uses for it. Importantly, I made the Fire TV purchase after I accounted for payments for food, shelter, transportation, clothing, and other higher priority items. The Fire TV was lower on my value-scale than these other items, but still high enough that I traded away money to get it.
Price couples directly into the value-scale
My value-scale very much depends on price. If the Fire TV cost twice what it actually does, I might not have bought it. If it cost ten times what it does, I definitely would not have bought it. It would have fallen much further down my value-scale, and I would have done something else with the $90 I actually used to buy it.
That’s how we get back to price as a manifestation of the subjective value of individuals. As prices of items move up and down, my value-scale adjusts accordingly. So do the value-scales of everyone else. Prices and our subjective valuations fluctuate in time. It’s a dynamic system. That’s the market in action.
Prices are woven deeply into something totally subjective: how different people assign relative values to different goods and services. Thus, prices themselves are not objective. They reflect the cumulative valuation judgments of participants in a market.
Remember Douglas Hubbard? He’s the guy I mentioned earlier, the one that thinks you can measure things like leadership and innovation. He wrote a book titled How to Measure Anything. It’s fantastic. I highly recommend it.
This is what Douglas Hubbard says, on page 292. The emphasis is his.
To reiterate, valuation, by its nature, is a subjective assessment. Even the market value of a stock or real estate is just the result of some subjective judgments of market participants. If people compute the net equity of a company to get an “objective” measure of its value, they have to add up things like the market value of real estate holdings (how much they think someone else would be willing to pay for it), the value of a brand (at best, how much more consumers are willing to pay for a product with said brand), the value of used equipment (again, how much someone else would pay for it), and the like. No matter how “objective” they believe their calculation is, the fundamental unit of measure they deal in—the dollar—is a measure of value.
That’s why anything that’s measured in dollars is subjective. It’s built entirely around the subjective judgments of individual people. And these judgments are constantly changing, mostly in small ways, but sometimes in big ways.
The subjective nature of inflation
Inflation is the process by which prices rise with the passing of time, making a dollar in the future worth less than a dollar in the past. In other words, a single dollar in the past had greater purchasing power than a single dollar in the future.
To measure inflation, we study the price of a market basket of goods. In the United States, the consumer price index is the best known measure of inflation. It tracks price movements across many segments of the economy:
• Food and beverages
• Medical care
• Education and communication
• Other goods and services
The idea is to cover such a large fraction of the economy that changes in personal preferences across segments get washed out. Let’s use another example.
Take transportation services, like Uber and Lyft. As these services become more popular, fewer people will buy and drive their own cars. Prices across the transportation sector will likely fall. The value-scales of consumers will change, driven by the changing economics of transportation.
Consumers may, then, find more value in recreation. In aggregate, they would choose to spend money they saved from reduced transportation prices on recreation, which would drive up prices in that sector. With a broad market basket, our inflation metric would try, in a very coarse way, to average out the price effects of the ever-changing value-scales of consumers.
Changing consumer preferences isn’t the only source of price movements. As the supply of money in the economy increases, prices should increase as well. We have more dollars chasing the same volume of goods and services.
Unfortunately, we can’t separate the impact of an increasing money supply from the impact of changing consumer value-scales. At the end of the day, the prices we see are determined in part by the totally subjective valuations of individual consumers. That’s why, even with the most sophisticated statistical tools at our disposal, we simply can’t divine an objective measure of any economic quantity. Anything measured in dollars and cents is built on a totally subjective foundation.
So what? What’s the problem with building corporate finance on a subjective foundation?
It’s not a huge problem, per se, that everything measured in dollars and cents has a subjective foundation. The real problem emerges under two conditions:
1. When we focus too heavily on financial constructs, like earnings and leverage, believing they are solid in a way that culture, innovation capacity, and brand strength aren’t.
2. When we focus too much on money, and not enough on the exchange that the money mediates.
Let me dive into this second point just a bit. Money is simply a medium of exchange. It allows us to trade one product or service for another. If anything, money is a distant secondary consideration. The primary elements are the products or services being exchanged.
Money is like a variable that gets canceled out of an equation. At your day job, you create something. You receive monetary compensation for what you create. You then use that money to buy products and services.Â
The money isn’t the dominant feature of that narrative. What’s most interesting, by far, is what we create and what we consume. Money simply helps us trade our productivity for consumption. Money is a stand-in, helping us separate transactions that otherwise would be coupled.
We focus so much on money because it’s ubiquitous. It’s a part of nearly every economic exchange. It’s easily measurable. And there’s romance to it. People love money.
But money, itself, isn’t objective, and doesn’t represent anything interesting. It’s the lubricant that keeps our economic engines turning. If we believe too much in the centrality and objectivity of money, we lose sight of the fundamental link between productivity and consumption.
Do you, personally, want to be wealthier? Produce more! Or find someone to pay you more for what you already produce. Do we, as a society, want to be wealthier? We need to produce more! In the aggregate, we won’t find someone to pay more for the goods and service we produce. Market forces govern the dynamics between supply, demand, and prices. The only useful lever at our disposal is our productivity.
Money itself isn’t going to solve any of our problems. We have to find a way to produce more. We can’t just produce anything, though. We have to produce things that are sufficiently high on the value-scales of consumers. And that draws us back to the subjective foundation of our economy. It’s the subjective valuations of individuals that drive the individual exchanges, or transactions, that comprise our economy.
The point is, don’t fool yourself over the supposed objective nature of money, or of quantities measured in dollars and cents. They are all built on a subjective foundation. Think more about the exchanges that these dollars and cents mediate. Think about what is being produced, and what is being consumed. Eliminate the distraction of money, and you are much more likely to unearth the most interesting economic realities that determine the wealth of individuals, companies, countries, and the world.