Ativo Capital

Rigorous Thinking


Financial and economic commentary reflecting Ativo’s world view:

Alan Greenspan on Stock Price and Capital Spending

Monday, April 21, 2014

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Taking a few vacation days this past week has given me time to read Alan Greenspan’s latest book, The Map and The Territory.  His comments on page 84 were particularly interesting:

The ratio of stock price to cost of construction of capital assets correlated quite well with machinery orders (capital investment) going back into the 1920s.  I recently updated the 1959 analysis and was amazed at how well this simple relationship still works, even tracing the recent years’ sharp fluctuations in real private capital investment.  Since 1993, for example, a 10 percent change in stock prices relative to the cost of replacing plant and equipment from scratch has been associated with a 4 percent change in real capital expenditures relative to the stock of fixed assets.

I know of no corporate executives who explicitly determine a corporation’s total budget based on such calculations, but implicitly they all do.  (emphasis ours)

In a footnote to his comments, Greenspan points out that his approach was a precursor to Tobin’s Q ratio, a metric that we’ve computed and relied on for decades.  Greenspan’s words are different from ours, but his conclusion is the same:  Companies grow when the value of the enterprise is greater than the value of the underlying assets (i.e., when the Q ratio is greater than one).  At Ativo, this means finding and understanding companies with a long term ROI above their implicit cost of capital.  Sustaining profitable growth is essential to creating long-term value for investors.      

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