Corporate valuations and national value

Mega Corp Inc

The mega-cap stocks dominate the American stock market. These are companies with a market capitalization of over 1 trillion dollars. As of today, they comprise over 25% of the stock market. Despite the recent market upheaval and the debate about the generative AI bubble, these mega-caps are here to stay, and they have elicited comparisons with the GDP of some of the rich nations. For instance, in an interview with Tim Cook, the singer Dua Lipa compared Apple to the GDPs of France and the United Kingdom.

At first glance, equating a company's market capitalization with a country's GDP might seem striking, and the intent might be to highlight the immense economic power concentrated in a few corporations. However, this analogy is fundamentally flawed. Market capitalization and GDP are inherently different metrics. Directly comparing them is akin to juxtaposing a person's net worth with their annual income; both are monetary figures?but?reflect different dimensions of financial reality. In economic terms, a company’s market capitalization is a stock measure representing the total value of a company's shares at a given moment. On the other hand, the GDP is a flow measure quantifying the value of goods and services produced by a nation over a period.

So, what is a better way to compare a country to a corporation, if there is one?

Valuation – back to fundamentals

Let’s explore the principles used by analysts to value shares. What gives a company its value? A fundamental finance principle states that the value of any asset is the discounted value of all future cash flows it will produce.

A company's free cash flow is the cash remaining in the company’s accounts after covering all operating expenses, taxes, and capital expenditures. This represents the amount available for debt repayment, dividends, or reinvestment. To illustrate, imagine you own 1,000 acres of farmland in Iowa, producing 100,000 bushels of corn annually, which you sell for $1 million. Your costs—including fertilizer, seeds, labor, and other expenses—total $700,000, and you spend an additional $100,000 on equipment and maintenance. After these expenses, you have $200,000 left as free cash flow for financial obligations, dividends, or future investments.

To apply this analogy to Apple, the free cash flow would be the revenue from selling various electronic products, such as the iPhone, minus expenses like engineers' salaries, production costs, shipping, warehousing, and retailing.

Once a company's free cash flow for a year is determined, the next step is to project this cash flow into the future. To do this, we need to estimate the growth rate of the company's cash flows and determine an appropriate discount rate.

The discount rate is the rate of return that investors require, given the company's risk profile. More risk should imply more return. A capitalist investing in the American government’s bond will expect to earn what is known as the risk-free rate. This would be the rate set by the government, as the American government’s risk of default on its debt obligation is almost zero. On the other side of the investment coin, the risk of a startup company’s failure is very high, and therefore, only so-called “accredited investors” would be allowed to speculate in those shares. In between those two lies the large spectrum of investment opportunities that the stock market, the real estate market, and the bond market would offer. For a piece of agricultural land, that rate of return would be related to the future market price of corn contracts.

Back to Apple, you would expect its discount rate to be similar to that of other big technology companies. Indeed, it is closest to Microsoft's. The discount rate for companies is typically the Weighted Average Cost of Capital (WACC). It considers the mix of debt and equity on the balance sheet and reflects the average rate of return required by all of the company's investors. This rate is used internally by the company's managers to evaluate whether they should take on any new projects. Apple's discount rate as of this writing in 2024 is approximately 9.6%. This means that any project should have a rate of return of more than 9.6% for the company to create value. Otherwise, it destroys value, and the money is best returned to investors.

With the discount rate in hand, we will discount each future cash flow back to its present value by dividing it by “1 plus the discount rate” raised to the power of the number of (time) periods. If you were to earn $1,000 in two years and your discount rate is 10%, then the present value of that today is $826.45.

A company that is a going concern and expected to stay operational for the foreseeable future is anticipated to keep generating cash indefinitely. In the history of the American stock market, a few companies have lasted over a hundred years; two notable examples are IBM and GE. However, a company is not expected to grow as quickly in the future as it did in the past unless it transforms itself. Therefore, analysts often project cash flows for the next five to ten years based on historical trends and reasonable growth assumptions. After this period, a terminal value is calculated to account for all future cash flows beyond that point.

For instance, if we were to value a gold mine, the terminal value might be the expected sale price after the mine is depleted. Assuming the company will last indefinitely, we use the perpetuity formula to calculate the terminal value for a company like Apple. This involves considering a perpetual growth rate, typically modest and less than the discount rate. The math works out as long as the growth rate is less than the discount rate and the value is a constant. One way to think about this value is by?adding infinitely decreasing numbers. Eventually, and as an answer to Zeno’s paradox, the sum converges.

The method covered is known as fundamental analysis, and it is believed that eventually, all stocks on the market will converge towards the value dictated by this analysis. The reason is the no-arbitrage theory, which states that there is no free money. However, the market capitalization of companies is determined by supply and demand for stocks and the psychology of traders. Some might perceive a company to have more value than what fundamental analysis dictates, which is why we might have bubbles in the market.

A Nation’s Yearly Added Value

Gross Domestic Product (GDP) sums the final outputs of a country. It is a statistical measure compiled by a nation's economists or international organizations. One perspective is that it reflects the total output of goods and services produced by all companies. Another is that it represents the total amount consumers in a country spend on these outputs. A third view is that it captures the total income earned by everyone in a country—all within a given year.

GDP represents the flow of economic activity within a nation over a period of time (a year), not the accumulated wealth. It captures the economy's capacity to generate income and output but does not directly account for national assets or liabilities. GDP measures a nation's economic performance in a given year, reflecting its productivity and efficiency.

Is this the equivalent of a year’s worth of free cash flow? Consider an individual, Cleo. After receiving her salary, Cleo pays her bills at the end of the month—such as credit card payments, rent, electricity, and internet. What remains is her free cash flow from working. If that value is negative, she is sinking further into debt. In addition to her monthly cash flow, Cleo has assets: money in her bank accounts, stocks in her retirement fund, or equity in her home. We reduce from this her credit card debts, mortgage, and any other debts she might owe. These net assets represent her net worth. GDP accounting stops at Cleo’s salary, which goes into the GDP figure. GDP is not a nation’s free cash flow. One way to look at GDP is as the total income earned by the nation's individuals during a year.

Shareholder nations

In his Capital in the Twenty-First Century, economist Thomas Piketty calculated the total wealth of Western nations to be equivalent to about six times their annual GDP. While the exact numbers may vary, the key takeaway is that a nation's total wealth is several times its annual output.

Given that a stock's value measures all its future cash flows, instead of thinking that Apple is as valuable as France (whose GDP is about three trillion dollars), we might consider that France could potentially purchase all the companies in the Nasdaq. Indeed, in America, most people put their retirement savings in the stock market and, therefore, own stocks and companies.

So, a more appropriate comparison between a corporation and a nation is to compare the company's market capitalization with the nation's total wealth, not its GDP. If we consider that France's total national wealth is approximately six times its annual GDP—amounting to around 18 trillion dollars—Apple's market capitalization of about 2 trillion dollars is a fraction of France's total wealth. This perspective underscores the vast economic scale of nations relative to even the largest corporations.

In addition, a nation's wealth encompasses not just its corporations but also its natural resources, real estate, infrastructure, and the cumulative skills and knowledge of its population. This holistic wealth is far more extensive and multifaceted than the market capitalization of any single company or even a group of companies.

Terminating the immortals

Remember the concept of terminal value above. Corporations are valued as if their growth rate is less than the discount rate. But history shows that humanity has made big jumps in its wealth-producing capacity. Our numbers increase, and so does our ingenuity. An economist valuing the East India Company back then would have never imagined the great inventions, globalization, and the end of colonization that were to come. If you believe in the infinite potential of the human spirit, then no national account can put a terminal value on the wealth of a nation. A poor country like South Korea in the 1950s could become an economic giant 70 years later. This is something that companies specialized in specific products can never achieve.

The real danger is that the mega-cap companies that wield significant economic influence will use it to gain political power in nations and stop the innovations that will render them moot and bankrupt. This is why national power should remain with citizens, with an equal distribution of political power.

While it might be tempting to draw parallels between mega-cap corporations' market capitalization and nations' GDP for dramatic effect, such comparisons are fundamentally flawed. Understanding these distinctions is crucial for accurate economic analysis and a healthy worldview. This way, we foster a more nuanced and informed discussion about economic power, wealth distribution, and the intricate relationships between global businesses and the countries in which they operate.