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# Market Capitalization Calculation Stock

Valuation Formula
A market capitalization calculation is a critical part of any stock valuation
formula. Market capitalization (sometimes called market cap) is the total
market value of all the companys outstanding shares. This represents the
value the market has placed on the value of a companys equity.
Market Capitalization Calculation
Market Capitalization = Number of shares outstanding multiplied by the price
of the stock.
Why is this Stock Valuation Formula Important?
The market capitalization is the valuation the market is giving the equity of
the whole company. When investors purchase a stock they are buying a
fractional share of the whole company. Therefore, market capitalization
represents the total price they would be paying for all of a companys stock.
Market capitalization gives you a metric with which to compare profits, cash
flows, revenues, expenses, assets, debt, etc. Remember, owning a stock
represents a fractional ownership of the company. Market Capitalization is
the current value for which you can buy and sell your fractional share of the
company. This makes it a relevant and important measurement for financial
analysis.
In the next several posts we will look at how market capitalization relates to
Calculating Enterprise Value of a company; and secondly, What is Net
Cash Flow.Then we will examine the Best Stock Valuation Calculation to
Value Company Shares is ROEV.

## Market capitalization refers to the value of a company's outstanding shares.

How It Works/Example:

## The formula for market capitalization is:

Market Capitalization = Current Stock Price x Shares Outstanding
It is important to note that market capitalization (sometimes called "market cap") is not the same
as equity value, nor is it equal to a company's debt plus its shareholders' equity (although that is
sometimes referred to as simply the company's capitalization).
Let's assume Company XYZ has 10,000,000 shares outstanding and the current share price is \$9.
Based on this information and the formula above, we can calculate that Company XYZ's market
capitalization is 10,000,000 x \$9 = \$90 million.
Why It Matters:

Market capitalization reflects the theoretical cost of buying all of a company's shares, but usually
is not what the company could be purchased for in a normal merger transaction. To estimate what
it would cost for an investor to buy a company outright, the enterprise value calculation is more
appropriate.
Thus market capitalization is a better measure of size than worth. That is, market capitalization is
not the same as market value, which can generally only be assigned when the company is
actually sold.

Market capitalization
Market capitalization (often simply market cap) is the total value of the tradable shares of a
publicly traded company; it is equal to the share price times the number of shares outstanding. As
outstanding stock is bought and sold in public markets, capitalization could be used as a proxy
for the public opinion of a company's net worth and is a determining factor in some forms of
stock valuation. Preferred shares are not included in the calculation.

The total capitalization of stock markets or economic regions may be compared to other
economic indicators. The total market capitalization of all publicly traded companies in the
world was US\$51.2 trillion in January 2007[1] and rose as high as US\$57.5 trillion in May 2008[2]
before dropping below US\$50 trillion in August 2008 and slightly above US\$40 trillion in
September 2008.[2]

Contents
[hide]

1 Valuation

## 2 Categorization of companies by capitalization

3 Related measures

5 References

 Valuation
Market capitalization represents the public consensus on the value of a company's equity. In a
public corporation, ownership interest is freely bought and sold through purchases and sales of
stock, providing a market mechanism (price discovery), which determines the price of the
company's shares. Market capitalization is defined as the share price multiplied by the number of
shares in issue, providing a total value for the company's shares outstanding.
Market capitalization is the total dollar market value of all of a company's outstanding shares.
Market capitalization is calculated by multiplying a company's shares outstanding by the current
market price of one share. The investment community uses this figure to determine a company's
size, as opposed to sales or total asset figures
If a company has 35 million shares outstanding, each with a market value of \$100, the company's
market capitalization is \$3.5 billion (35,000,000 x \$100 per share).
Many companies have a dominant shareholder, which may be a government entity, a family, or
another corporation. Many stock market indices such as the S&P 500, Sensex, FTSE, DAX,

Nikkei, Ibovespa, and MSCI adjust for these by calculating on a free float basis, i.e. the market
capitalization that they use is the value of the publicly tradable part of the company. Thus,
market capitalization is one measure of "float" i.e., share value times an equity aggregate, with
free and public being others.
Note that market capitalization is based on a market estimate of a company's value, based on
perceived future prospects, economic and monetary conditions. Stock prices can also be moved
It is possible for stock markets to get caught up in an economic bubble, like the steep rise in
valuation of technology stocks in the late 1990s followed by the dot-com crash in 2000. Hype
can affect any asset class, such as gold or real estate. In such events, valuations rise
disproportionately to what many people would consider the fundamental value of the assets in
question. In the case of stocks, this pushes up market capitalization in what might be called an
"artificial" manner. Market capitalization is, therefore, only a rough measure of the true size of a
market. However, it does represent the best estimate of all market participants at any point in
timebubbles are easy to spot retrospectively, but if a market participant believes a stock is
overvalued, then of course they can profit from this by selling the stock (or shorting it, if they
don't hold it).

##  Categorization of companies by capitalization

Traditionally, companies were divided into large-cap, mid-cap, and small-cap. The terms
mega-cap and micro-cap have also since come into common use, and nano-cap is sometimes
heard.[3] Different numbers are used by different indexes;[3][4] there is no official definition of, or
full consensus agreement about, the exact cutoff values. The cutoffs may be defined as
percentiles rather than in nominal dollars. The definitions expressed in nominal dollars need to
be adjusted over the decades due to inflation, population change, and overall market valuation
(for example, \$1 billion was a large market cap in 1950, but it is not very large now), and they
may be different for different countries. A rule of thumb may look like:

## Nano-cap: Below \$50 million

Cap is short for capitalization, a measure by which we can classify a company's size. Big/Large
caps are companies that have a market cap between \$10-200 billion dollars. Mid caps range from

\$2 billion to \$10 billion dollars. Small caps are typically new or relatively young companies and
have a market cap between \$100 million to \$1 billion dollars. SmallCap's track record won't be
as lengthy as that of the Mid to MegaCaps. SmallCaps do present the possibility of greater
capital appreciation, but at the cost of greater risk.

##  Related measures

Market cap reflects only the equity value of a company. It is important to note that a firm's choice
of capital structure has a significant impact on how the total value of a company is allocated
between equity and debt. A more comprehensive measure is enterprise value (EV), which
includes debt, preferred stock, and other factors. Insurance firms use a value called the embedded
value (EV).

Financial ratio

Free float

## List of corporations by market capitalization

Market price

Market trends

Public float

Shares authorized

Treasury stock

 References
1.

2.

## ^ a b WFE Report Generator including report for Domestic Market Capitalization

2008 (World Federation of Exchanges)

3.

^ a b According to Investopedia. (Investopedia also lists a definition for "nanocap", but that term is not in wide use.)

4.

## ^ Definition of Market Capitalization

by adding citations to reliable sources. Unsourced material may be challenged and
removed. (January 2008)

Look up market capitalization in Wiktionary, the free dictionary.

How to Value Assets - from the Washington State (U.S.) government web site

[hide]

Stock market
Types of
stocks
Share
capital
Participants
Exchanges

## Common stock Concentrated stock Golden share Growth stock Preferred

stock Restricted stock Tracking stock
Shares authorized Issued shares Shares outstanding Treasury shares
Broker-dealer Floor broker Floor trader Investor Market maker Proprietary
Electronic communication network Market opening times Over-the-counter
Stock exchange (list) Multilateral trading facility

Stock
Alpha Arbitrage pricing theory Beta Book value CAPM Dividend yield
valuation Earnings per share Earnings yield Gordon model SCL SML T-Model
Cap rate D/E ratio Dividend cover Dividend payout ratio EV/EBITDA
Financial EV/GCI EV/Sales CROCI P/B ratio P/CF ratio P/E PEG P/S ratio
ratios
RAROC ROA ROCE ROE ROTE ROIC SIR SGR Sharpe ratio
Treynor ratio

## Efficient-market hypothesis Fundamental analysis Market timing Modern

theories
portfolio theory Momentum investing Mosaic theory Pairs trade Postand
modern portfolio theory Random walk hypothesis Style investing Swing
strategies

Related
terms

## Block trade Cross listing Dark liquidity Dividend Dual-listed company

DuPont Model Flight-to-quality Haircut IPO Margin Market anomaly
Market capitalization Market depth Market manipulation Market trend
Mean reversion Momentum Open outcry Public float Rally Reverse stock
split Short selling Slippage Speculation Stock dilution Stock split Trade
Uptick rule Volatility Voting interest Stock market index

## Barron's Finance & Investment Dictionary:

turnover
Top
Home > Library > Business & Finance > Finance and Investment Dictionary
Finance:
1. number of times a given asset is replaced during an accounting period, usually a year.
2. ratio of annual sales of a company to its net worth, measuring the extent to which a company
can grow without additional capital investment when compared over a period.
Great Britain: annual sales volume.
Industrial relations: total employment divided by the number of employees replaced during a
given period.
Securities: volume of shares traded as a percentage of total shares listed on an exchange during a
period, usually either a day or a year.
The same ratio is applied to individual securities and the portfolios of individual or institutional

investors.
some of its promotion expenses. Adopted by the Securities and Exchange Commission in 1980,
Rule 12b-1 provides mutual funds and their shareholders with an asset-based alternative method
of covering sales and marketing expenses. At least half of the more than 10,000 mutual funds in
existence today have a 12b-1 fee typically ranging from .25%, in the case of no-load funds that
use it to cover advertising and marketing costs, to as high as 8.5%, the maximum front-end
load allowed under National Association of Securities Dealers (NASD) rules, in cases where
fees is in funds sold through brokers, insurance agents, and financial planners.
Changes to 12b-1 that became effective July 7, 1993, aim to limit fees paid by most fund
investors to the 8.5% limit on front-end loads.
This is achieved by an annual limit and by a rolling cap placed on new sales. The annual limit is .
85% of assets, with an additional .25% permitted as a service fee. The rolling cap on the total of
all sales charges is 6.25% of new sales, plus interest, for funds that charge the service fee, and
7.25%, plus interest, for funds that do not. The new regulation also prohibits funds with frontend, deferred, and/or 12b-1 fees in excess of .25% from being called no-load. See also mutual
Turnover

Turnover is sometimes a synonym for revenue (or in certain contexts, sales), especially in
European and South African usage

## Services sold by a company during a particular period of time.

Turnover is sometimes the name for a measure of how quickly inventory is sold
(inventory turnover), . A high turnover means that goods are sold quickly, while a low
turnover means that goods are sold more slowly.
o Asset turnover is a financial ratio that measures the efficiency of a company's use
of its assets in generating sales revenue or sales income to the company.[1]

Turnover (employment), relative rate at which an employer gains and loses staff,
especially in North American usage

Customer turnover, the rate at which a business loses customers, sometimes called the
churn

 Biology

Cell turnover refers to the replacement of old cells with newly generated ones.[2]

 Sports

Turnover (gridiron football), in American football occurs when the offense loses
possession of the football because of a fumble, interception, or on downs

Turnover (basketball), a turnover in basketball occurs when a player from one team gives
possession to the opposing team by losing the ball without taking a shot

Turnover (rugby union), a turnover in rugby union occurs when a team loses possession
in a ruck or a maul

Turnover (rugby league), a turnover in rugby league occurs when a team loses possession
or at the end of a team's six tackles

 Demographics

Population turnover, measures gross moves in relation to the size of the population and is
related to population mobility

##  Chemical kinetics

Turnover number, is the number of moles of substrate that a mole of catalyst can convert
before becoming inactivated. In enzyme kinetics, the same term is used to refer to the
moles of substrate converted by a mole of enzyme per second

 Music

 Food

Financialization

## Financialization is a term sometimes used in discussions of financial capitalism which

developed over recent decades, in which financial leverage tended to override capital (equity)
and financial markets tended to dominate over the traditional industrial economy and agricultural
economics.
Financialization is a term that describes an economic system or process that attempts to reduce
all value that is exchanged (whether tangible, intangible, future or present promises, etc.) either
into a financial instrument or a derivative of a financial instrument. The original intent of
financialization is to be able to reduce any work-product or service to an exchangeable financial
instrument, like currency, and thus make it easier for people to trade these financial instruments.
Workers, through a financial instrument such as a mortgage, could trade their promise of future
work/wages for a home. Financialization of risk-sharing makes all insurance possible, the
financialization of the U.S. Government's promises (bonds) makes all deficit spending possible.
Financialization also makes economic rents possible.
Contents
[hide]

2 Roots

## 3 Financial turnover compared to gross domestic product

4 Futures markets

5 Economic effects
o

## 6 The development of leverage and of financial derivatives

9 Notes

Actually, various definitions, focusing on specific aspects and interpretations, have been used:

Greta Krippner of the University of California, Los Angeles has written that
financialization refers to a pattern of accumulation in which profit making
occurs increasingly through financial channels rather than through trade and
commodity production. In the introduction to the 2005 book Financialization
and the World Economy, editor Gerald A. Epstein wrote that some scholars
have insisted on a much more narrow use of the term: the ascendancy of
"shareholder value" as a mode of corporate governance; or the growing
dominance of capital market financial systems over bank-based financial
systems. Pierre-Yves Gomez and Harry Korine in their 2008 book
"Entrepreneurs and Democracy: a political theory of corporate governance"
have identified a long-term trend in the evolution of corporate governance of
large corporations and they have shown that financialization is one step in
this process.

## Financialization refers to the increasing importance of financial markets, financial motives,

financial institutions, and financial elites in the operation of the economy and its governing
institutions, both at the national and international levels.

## Michael Hudson summarized financialization in a 2003 interview: [3]

Companies are not able to invest in new physical capital equipment or buildings because they are
obliged to use their operating revenue to pay their bankers and bondholders, as well as junk-bond
holders. This is what I mean when I say that the economy is becoming financialized. Its aim is
not to provide tangible capital formation or rising living standards, but to generate interest,
financial fees for underwriting mergers and acquisitions, and capital gains that accrue mainly to
insiders, headed by upper management and large financial institutions. The upshot is that the
earning more, hourly earnings have declined in real terms. There has been a drop in net
disposable income after paying taxes and withholding "forced saving" for social Security and
medical insurance, pension-fund contributions andmost serious of alldebt service on credit
cards, bank loans, mortgage loans, student loans, auto loans, home insurance premiums, life
insurance, private medical insurance and other FIRE-sector charges. ... This diverts spending
away from goods and services.

## Financialization may be defined as: "the increasing dominance of the

finance industry in the sum total of economic activity, of financial controllers
in the management of corporations, of financial assets among total assets, of
marketised securities and particularly equities among financial assets, of the
stock market as a market for corporate control in determining corporate
strategies, and of fluctuations in the stock market as a determinant of

## More popularly, however, financialization is understood to mean the vastly

expanded role of financial motives, financial markets, financial actors and

## financial institutions in the operation of domestic and international

economies.

Sociological and political interpretation have also been made. In his 2006
book, American Theocracy: The Peril and Politics of Radical Religion, Oil, and
Borrowed Money in the 21st Century, American writer and commentator
Kevin Phillips presented financialization as a process whereby financial
services, broadly construed, take over the dominant economic, cultural, and
political role in a national economy. (page 268). Philips considers that the
financialization of the U.S. economy follows the same pattern that marked the
beginning of the decline of Habsburg Spain in the 16th century, the Dutch
trading empire in the 18th century, and the British Empire in the 19th
century: (It is also worth pointing out that the true final step in each of these
historical economies is; collapse)
... the leading economic powers have followed an evolutionary progression:
first, agriculture, fishing, and the like, next commerce and industry, and
finally finance. Several historians have elaborated this point. Brooks Adams
contended that as societies consolidate, they pass through a profound
intellectual change. Energy ceases to vent through the imagination and takes
the form of capital.

## Nassim Taleb discusses the role mis-estimated financialization methods and

processes can be the cause of disaster. In his book The Black Swan Taleb
points out how financialization can misrepresent reality and lead to large
errors. Relative to the 2007-2009 financial crisis it became clear that many
mortgages did not accurately represent the risk to the lendor or the promise
of future income from the borrower. Credit Default Swaps transactions initially
overwhelmed the marketplace as many rushed to correct the error caused by
the mis-financialization of borrowers' promises, i.e., mortgages. Nassim Taleb
in a 2001 work titled "Fooled by Randomness: The Hidden Role of Chance in
Life and in the Markets" foretold many of the errors in Financialization that
were being made at the time, those errors in Financialization ultimately
proved to be the major causes of the 2007-2009 financial crisis. Taleb
suggests that mis-financializations are the root causes of most systemic
economic problems in modern economies.

 Roots

In the American experience, the roots of financialization can be traced to the rise of
Neoliberalism and the free-market doctrines of Milton Friedman and the Chicago School of
Economics, which provided the ideological and theoretical basis for the increasing deregulation
of financial systems and banking beginning in the 1970s. Notre Dame heterodox economist
David Ruccio has summarized the politico-economic philosophy of Friedman and the Chicago
School as one in which markets, private property and minimal government will achieve
maximum welfare.

One of the most important impetuses to the rise of financialization was the end of the post-World
War Two Bretton Woods system of fixed international exchange rates and the dollar peg to gold
in August 1971.
In a 1998 article Michael Hudson discussed previous economists who saw the problems that
result from financialization.[4] Problems were found by John A. Hobson (it enabled Britain's
imperialism), Thorstein Veblen (it acts in opposition to rational engineers), Herbert Somerton
Foxwell (Britain was not using finance for industry as well as Europe), and Rudolf Hilferding
(Germany was surpassing Britain and U.S. in banking that supports industry).
At the same 1998 conference in Oslo, Erik S. Reinert and Arno Mong Daastl in "Production
Capitalism vs. Financial Capitalism" provided an extensive bibliography on past writings, and
In the United States, probably more money has been made through the appreciation of real estate
than in any other way. What are the long-term consequences if an increasing percentage of
savings and wealth, as it now seems, is used to inflate the prices of already existing assets - real
estate and stocks - instead of to create new production and innovation?
 Financial turnover compared to gross domestic product

Other financial markets exhibited similarly explosive growth. Trading in U.S. equity (stock)
markets grew from \$136.0 billion or 13.1 percent of U.S. GDP in 1970, to \$1.671 trillion or 28.8
percent of U.S. GDP in 1990. In 2000, trading in U.S. equity markets was \$14.222 trillion, or
144.9 percent of GDP. Most of the growth in stock trading has been directly attributed to the
According to the March 2007 Quarterly Report from the Bank for International Settlements (see
page 24.):
Trading on the international derivatives exchanges slowed in the fourth quarter of 2006.
Combined turnover of interest rate, currency and stock index derivatives fell by 7% to \$431
trillion between October and December 2006.
Thus, derivatives trading mostly futures contracts on interest rates, foreign currencies, Treasury
bonds, etc. had reached a level of \$1,200 trillion, \$1.2 quadrillion, a year. By comparison, U.S.
GDP in 2006 was \$12.456 trillion.

The table below provides data for the annual amount of financial trading in U.S. financial
markets, compared to GDP.

## Sources for table above:

Equity Markets Trading, Statistical Abstract of the United States. For example
1990 and 2000 taken from Table 1201, Sales of Stocks on Registered
Exchanges, 1990 to 2003, "Market Value of all Sales" minus "CBOE" Statistical
Abstract of the United States, 2004-2005.

## U.S. government securities trading, Statistical Abstract of the United States.

For example 1990 and 2000 taken from Table 1190, Volume of Debt Markets
by Type of Security, 1990 to 2003, Statistical Abstract of the United States
2004-2005.

Futures Trading, are estimates based on the average value of types of futures
contracts, multiplied by the number of contracts traded, reported by the
Futures Industries Association.

Corporate Debt Trading and State and Municipal Bonds, the Bond Market
Association reports average daily volume, multiplied by 240 business days.

## Options trading, on exchange, Statistical Abstract of the United States. For

example 1990 and 2000 taken from Table 1201, Sales of Stocks on Registered
Exchanges, 1990 to 2003, line for "CBOE" only, Statistical Abstract of the
United States, 2004-2005.

Mortgage Derivatives, 2000 taken from Table 1190, Volume of Debt Markets
by Type of Security, 1990 to 2003, Statistical Abstract of the United States
2004-2005.

OTC swaps, forwards, options is reported by the U.S. Federal Reserve Bank of
New York, and the Bank for International Settlements, but I have not been
able to determine what percentage of nominal values of these types of

##  Futures markets

The data for turnover in the futures markets in 1970, 1980, and 1990, is based on the number of
contracts traded, which is reported by the organized exchanges, such as the Chicago Board of
Trade, the Chicago Mercantile Exchange and the New York Commodity Exchange, and compiled
in data appendices of the Annual Reports of the U.S. Commodity Futures Trading Commission.
The pie charts below show the dramatic shift in types of futures contracts traded from 1970 to
2004. For a century after organized futures exchanges were founded in the mid-19th century, all
futures trading was solely based on agricultural commodities.
But after the end of dollar gold-backed fixed-exchange rate system in 1971, contracts based on
foreign currencies began to be traded. After the deregulation of interest rates by the Bank of
England, then the U.S. Federal Reserve, in the late 1970s, futures contracts based on various
bonds / interest rates began to be traded. The result was that financial futures contracts - based on
such things as interest rates, currencies, or equity indices - came to dominate the futures markets.

The dollar value of turnover in the futures markets is found by multiplying the number of
contracts traded by the average value per contract for 1978 to 1980, which was calculated by
ACLI Research in 1981. The figures for earlier years were estimated on computer-generated
exponential fit of data from 1960 to 1970, with 1960 set at \$165 billion, half the 1970 figure, on
the basis of a graph accompanying the ACLI data, which showed that the number of futures
According to the ALCI data, the average value for interest rate contracts is around ten times that
of agricultural and other commodities, while the average value of currency contracts is twice that
of agricultural and other commodities. (Beginning in mid-1993, the Chicago Mercantile
Exchange itself began to release figures of the nominal value of contracts traded at the CME
each month. In November 1993, the CME boasted it had set a new monthly record of 13.466
million contracts traded, representing a dollar value of \$8.8 trillion. By late 1994, this monthly
value had doubled. On. Jan. 3, 1995, the CME boasted that its total volume for 1994 had jumped
54%, to 226.3 million contracts traded, worth nearly \$200 trillion. Soon thereafter, the CME
ceased to provide a figure for the dollar value of contracts traded.)
 Economic effects

Financial services (banking, insurance, investment...) has become a key industry in developed
economies in which it represents a sizeable share of the GDP and an important source of
employment. Those activities also played a key facilitator role to foster economic globalization.
In the wake of the 2007-2010 financial crisis, a number of economists and others began to argue
that Financial services had become too large a sector in the U.S. economy, with no real benefit to
society accruing from the activities of increased financialization. Some, such as former
International Monetary Fund chief economist Simon Johnson even went so far as to argue that
the increased power and influence of the financial services sector had fundamentally transformed
the American polity, endangering representative democracy itself.[6]
In February 2009, white-collar criminologist and former senior financial regulator William K.
Black listed the ways in which the financial sector harms the real economy. Black wrote, The
financial sector functions as the sharp canines that the predator state uses to rend the nation. In
addition to siphoning off capital for its own benefit, the finance sector misallocates the remaining
capital in ways that harm the real economy in order to reward already-rich financial elites
harming the nation.[7]
In testimony before the U.S. Congress in March 2009, former Federal Reserve Chairman

## Alan Greenspan has proclaimed himself "shocked" that "the self-int

Scandinavians have upgraded the skills and wages of their workers

Emerging countries also try to develop their financial sector, as an engine of economic
development. A typical aspect is the growth of microfinance/microcredit.
On 15 February 2010, Adair Turner, head of Britains Financial Services Authority directly
blamed financialization as a primary cause of the 20072010 financial crisis. In a speech before
the Reserve Bank of India, Turner said that the Asian financial crisis of 1997-98 was similar to
the 2008-2009 crisis in that ...both were rooted in, or at least followed after, sustained increases
in the relative importance of financial activity relative to real non-financial economic activity, an
increasing financialisation of the economy. [9]
 Criticism of financialization

This recognized success brought also some negative reactions. In the Introduction to the 2005
book Financialization and the World Economy, editor Gerald A. Epstein wrote that
... finance benefits handsomely from the same processes that create economic crises and injure so
many others. Hence the costs of financial crises are paid by the bulk of the population, while

large benefits accrue to finance. Dumnil and Lvy provide new and valuable data documenting
these trends in the case of France and the USA....
 The development of leverage and of financial derivatives

One of the most notable features of financialization has been the development of overleverage
(more borrowed capital and less own capital) and, as a related tool, financial derivatives
financial instruments, the price or value of which is derived from the price or value of another,
underlying financial instrument. Those instruments, which initial purpose was hedging and risk
management, has become widely traded financial assets in their own. The most common types of
derivatives are futures contracts, swaps, and options. In the early 1990s, a number of central
banks around the world began to survey the amount of derivative market activity, and report the
results to the Bank for International Settlements.
In the past few years, the number and types of financial derivatives have grown enormously. In
November 2007, commenting on the financial crisis sparked by the sub-prime mortgage collapse
in the United States, Doug Nolands Credit Bubble Bulletin, on Asia Times Online, noted,
The scale of the Credit "insurance" problem is astounding. According to the Bank of
International Settlements, the OTC market for Credit default swaps (CDS) jumped from \$4.7 TN
at the end of 2004 to \$22.6 TN to end 2006. From the International Swaps and Derivatives
Association we know that the total notional volume of credit derivatives jumped about 30%
during the first half to \$45.5 TN. And from the Comptroller of the Currency, total U.S.
commercial bank Credit derivative positions ballooned from \$492bn to begin 2003 to \$11.8 TN
as of this past June....
A major unknown regarding derivatives is the actual amount of cash behind a transaction. A
derivatives contract with a notional value of millions of dollars may actually only cost a few
thousand dollars. For example, an interest rate swap might be based on exchanging the interest
payments on \$100 million in U.S. Treasury bonds at a fixed interest of 4.5 percent, for the
floating interest rate of \$100 million in credit card receivables. This contract would involve at
least \$4.5 million in interest payments, though the notional value may be reported as \$100
million. However, the actual cost of the swap contract would be some small fraction of the
minimal \$4.5 million in interest payments. The difficulty of determining exactly how much this
swap contract is worth when accounted for on a financial institutions books, is typical of the
worries many experts and regulators have over the explosive growth of these types of
instruments.
Contrary to common belief in the United States, the largest financial center for derivatives - and
also for forex - is London. According to MarketWatch on December 7, 2006,

The global foreign exchange market, easily the largest financial market, is dominated by London.
More than half of the trades in the derivatives market are handled in London, which straddles the
time zones between Asia and the U.S. And the trading rooms in the Square Mile, as the City of
London financial district is known, are responsible for almost three-quarters of the trades in the
secondary fixed-income markets.

Capital turnover
Calculated by dividing annual sales by average stockholder equity (net worth). The ratio
indicates how much a company could grow its current capital investment level. Low capital
turnover generally corresponds to high profit margins.
Capital Turnover
A ratio of how effectively a publicly-traded company manages the capital invested in it to
produce revenues. It is calculated by taking the total of the company's annual sales and dividing
it by the average stockholder equity, which is the average amount of money invested in the
company. A high ratio indicates that the company is using its capital well, while a low ratio
indicates the opposite. It is also called equity turnover.
capital turnover
A measure indicating how effectively investment capital is used to produce revenues. Capital
turnover is expressed as a ratio of annual sales to invested capital.

## The Evolution of the Finance Growth Nexus

Paul Wachtel
28 September 2010

## Print Email Com

ment

This article discusses the historical role of the financial sector in improving
allocative efficiency thereby having a positive impact on TFP growth.
However, this article points out that it is difficult to estimate the complicated
relationship between financial deepening and economic growth.

Modern growth theory dates back to the mid 1950s, only a little more than 50
years, to the contributions made by Robert Solow and others. Solows
neoclassical production function approach attributes growth to the quantity of
capital and labor inputs and a catchall residual factor called total factor
productivity. Productivity studies tended to emphasize capital deepening,
improvements in labor quality (human capital investments) and the adoption
of new technologies.
The approach reached its zenith in the early 1990s with a controversial
literature on the rapid growth of the East Asian economies. Page (1994)
distinguishes between the fundamentalist and the mystic explanation for the
East Asian miracle. The fundamentalists stress the role of factor
accumulation; they attribute growth to high savings rates and capital
accumulation, and human capital development as an educated population
moved into the active labor force. The mystics place greater emphasis on the
role of the acquisition and mastery of technology. The controversy goes
beyond the analytics of the sources of growth. The mystics, unlike the
fundamentalists, were likely to support interventionist government
development policies. The fundamentalist view of growth in East Asia seems
to have won the debate although the argument regarding the efficacy of
interventionist industrial policies is as yet unsettled.
Empirical applications of the Solow framework tended to focus more and
more attention on total factor productivity (TFP). The great American
productivity slowdown in the 1970s and 1980s (the period between the oil
shocks and the high tech boom) was attributed to many factors but most
analyses were often left with a systematic and striking decline in TFP growth
Such a conclusion was very disquieting because it attributed changes in
growth rate to a great unknown residual. So, it comes as no surprise that
economists began to think about the sources of differences in TFP growth.
For example, the fundamentalists were aware of the fact that East Asian
resource accumulation was very different than the similarly large levels of
accumulation in the Soviet Union and other planned economies. The ability to
allocate resources efficiently is hard to measure and, as an omitted variable,
would be reflected in TFP growth.

## An important aspect of allocative efficiency is the role of the financial sector.

Although it was not a new idea, it was largely forgotten by development
economists who often called for explicit manipulation of financial markets
through subsidies, directed credit, interest rate controls and other means in
order to achieve development objectives. However, more market oriented
discussions of the role of the financial sector, such as Goldsmith (1969) and
McKinnon (1973), began to attract attention. The role of financial
intermediaries is to bring savers and investors together in a way that directs
savings into the most productive investments. The pooling of information and
the creation of financial instruments both induces more activity and promotes
efficient allocations. Thus, a country with a more developed or more
extensive financial system is likely to grow more. The value added by a
market oriented financial sector is that it promotes the efficient allocation of
resources.
This new understanding of the financial sector began to take root about the
same time that the fundamentalists and mystics were debating and an
empirical literature on the role of the financial sector in economic soon
emerged. However, empirical application requires some definition of the role
of the financial sector. Quickly, and perhaps mistakenly, the role of financial
institutions became to be defined by the size of the sectors activity. That is an
economy with more intermediary activity was assumed to be doing more to
generate efficient allocations. So, the level of intermediation to GDP was
taken as a broad measure of the size of the financial sector. A simple look at
the raw data supported the idea that countries with more intermediation grew
more rapidly. The table presents the average growth rates for 84 countries,
1960-2004 for quartiles of two commonly used financial depth ratios, M3 to
GDP Total private credit to GDP:

Financi
al
M3/GD Credit/GD
Depth
P
P
Quartile
s
1
(highest 2.81
)

2.84

2.20

2.41

1.65

1.21

0.68

0.94

(lowest)

## An extensive econometric literature emerged that held constant other

determinants of growth and used the most sophisticated techniques to control
for the simultaneity of growth and financial depth. Robert Barro (1991) and
Robert King and Ross Levine (1993) pioneered the use of cross country panel
data to examine the relationship while Paul Wachtel and Peter Rousseau
(1995) developed evidence based on long time series for the few countries
with available data. The literature grew rapidly and has been eloquently
summarized by its champion, Ross Levine, at least three times (1997, 2005,
and 2008). By the end of the 1990s, the finance-growth nexus was a well
established part of the economic canon.
However, the empirical literature might have over sold the nexus. In Wachtel
(2001, 2004), I pointed out that it is misleading to draw inferences about
policy objectives from the strong cross country results. First, there is wide
variation in the level of financial depth among countries with similar levels of
GDP per capita. Second, the between country variation is much larger than
the within country variation even over long periods of time. Thus the
variation in financial depth seems to be related to differences in institutional
structures among countries. As a consequence it is a mistake to draw any
causal inferences from the estimated effects of financial deepening on
economic growth.

For example, domestic credit to the private sector is typically about 40% in
middle income countries (e.g. 36% in Costa Rica with real GDP in 2005
dollars of about \$9000) and typically over 100% in high income countries
(e.g. 90% in Israel, 125% in New Zealand and 178% in Canada). The cross
section estimates of the effect of financial deepening on growth indicate that
at an increase in 50 percentage points will increase growth rates by one
percentage points. This is a very large effect, so large that concern about
reverse causality seems reasonable. Perhaps, following Joan Robinson,
The experiences of individual countries are also difficult to interpret. The
development of the American financial system in the late 19th century was
instrumental in understanding growth but 20th century developments are
harder to understand. The chart shows the increase in financial depth in the
US over the last 50 years; it presents the ratio of end of year Flow of Funds
data for Debt Outstanding of the Domestic Nonfinancial Sectors (FRED
series TODNS) to GDP (FRED series GDPA) from 1960 to 2009. There have
been two recent episodes of financial deepening in the US. The ratio

increased by about a third in the 1980s and again in the 2000s, otherwise
there is little movement. How should we interpret these episodes? Do they
represent periods of financial innovation and deeper financial activity which
improved resource allocation and contributed to the growth of the economy?
Or do they represent periods of increased leverage and risk taking which only
temporarily increases growth and can precipitate financial crises. In the first
instance, the stock market crash in 1987 did not have widespread macro
consequences but in the second instance, the housing crash in 2007 did.

Both the Asian financial crises in 1997 and the global financial crisis in 2007
have brought the role of financial deepening under closer scrutiny. Reinhart
and Reinhart (2010) look at 15 late 20th century severe financial crises
(including emerging market, the Asian experience and advanced economies
such as Japan and the Scandinavian banking crises). They describe the
commonalities of the 10 year pre-crisis periods. In each instance there was a
surge in the ratio of domestic bank credit to GDP prior to the crisis. The
median increase was 38.4 percentage points and the deleveraging in the postcrisis decade was about the same proportional size. The run up of the credit to
GDP ratio in the decade prior to the 2007 in the 9 countries that experienced
systemic crisis was even larger, about 60 percentage points.

## The role of credit deepening as a possible cause of crisis is found earlier in

Sachs and Radelet (1998) in their analysis of financial crises in emerging
market countries. A significant variable in their probit model to predict severe
reversals in capital flows is the private credit buildup, the increase over
three years in the ratio of private sector financial claims to GDP. Financial
depth is a bit of a chameleon; in some contexts it is a determinant of
economic growth and in another it is a precursor of crisis. As Peter Rousseau
suggested to me, one persons salubrious deepening is another persons
financial crisis.
Even without a financial crisis, there are difficulties in interpreting financial
deepening experiences. Consider the case of Croatia where monetary
stabilization and the end of hostilities led to rapid growth of intermediation in
the late 1990s. By all accounts, this was viewed as a desirable deepening.
However, a banking crisis in 1998-99 led to a contraction of credit. The
banking crisis was short-lived and within a year there was a consolidation of
the banking sector and privatization to foreign owners. A second credit boom
ensued in and by 2006 domestic credit to the private sector exceeded 70% of
GDP, more than double the level of decade earlier but still not unusually high
for a middle income country. The Croatian National Bank responded to the
rapid growth in lending by putting a tax on rapid lending growth and a
marginal reserve requirement on foreign borrowing. There was considerable
effort to distinguish between the gradual deepening of the financial sector and
rapid loan growth.
The financial sectors influence on economic growth is a complex
phenomenon. The issue at hand may not be the finance-growth nexus per se
but how we measure it. Aggregate data on credit to GDP ratios are useful
because it is possible to abstract from national institutions and make formal
cross country comparisons. But, the recent experiences described here make
abundantly clear that the financial depth ratios are a poor description of the
finance growth nexus.
As noted the use of financial depth ratios (and generalizations such as adding
the ratio of equity market capitalization to GDP) are a matter of convenience.
Theoretical arguments about the role of the financial sector relate to the
amount or quality of intermediary activity which need not be related to
financial depth. My NYU colleague, Thomas Philippon (2008) examines the
share of the financial sector in GDP in the US going back over 100 years. The
chart shows that there have been several periods of rapid increase in the
share. With one exception, Philippon associates these bursts in activity with
periods of innovation when young, cash-poor firms require finance:

The financial industry was around 1.5% of GDP in the mid-19th century.
The first large increase between 1880 to 1900 corresponds to the financing of
railroads and early heavy industries. The second big increase between 1918
and 1933 corresponds to the financing of the Electricity revolution, as well as
automobile and pharmaceutical companiesAfter a continuous collapse in
the 1930s and 40s, the GDP share of finance and insurance industries was
down to only 2.5% of GDP in 1947. It recovered slowly and was mostly
stable at around 4% until the late 1970s, and then grew quickly to reach 8.3%
of GDP in 2006. The third large increase, from 1980 to 2001, corresponds to
the financing of the IT revolution.

The one exception of course is the rapid after 2002. Philippons modeling
suggests that there was a bubble in this period resulted in a financial sector
that was about 10% larger than justified by economic fundamentals.
Looking at the specific activities of the financial sector and their contribution
towards growth is even more difficult. Financial innovations (e.g. derivatives,
securitization, etc.) are valued because they facilitate the functioning of the
sector. However, empirical analysis to evaluate the impact of specific
activities is so far elusive. A comment made by Paul Volcker in December
2009 has been widely quoted in this regard:
I wish somebody would give me some shred of evidence linking financial
innovation with benefit to the economy.
The ATM is the one innovation in the past 25 years that he was willing to cite:

## It really helps people. Its useful.

Two years past the global meltdown, where does the finance-growth nexus
stand? All in all, it is relatively unscathed. What we have learned is not that
finance is unimportant but, instead, we have learned how difficult it is to
measure financial sector activity properly.