When I talk to non-finance practitioners, one of the big mental blocks I encounter often is the difference between “money” and “value”.
For most people in daily life, the two terms seem to be fungible. Owning a share of Apple that’s worth about $208 as of 2019/5/7 is almost identical to owning $208 in cash or having $208 in the bank.
This is of course not the case as each one of the three cases has different meanings and none of it is really a mutually-exclusively existing substance on this planet, such as a certain pebble lying under the Rheine River or an apple hanging on the tree in your neighbor’s garden,
For example, both the $208 in cash and in the bank are part of the narrowly defined M1 Money Stock, defined as:
M1 is the money supply that includes physical currency and coin, demand deposits, travelers checks, other checkable deposits and negotiable order of withdrawal (NOW) accounts. The most liquid portions of the money supply are measured by M1 because it contains currency and assets that can be quickly converted to cash. “Near money” and “near, near money,” which fall under M2 and M3, cannot be converted to currency as quickly.
Note that the $208 you deposited in the bank could be lent out in the form of cash by the bank, subject to a reserve ratio. There’s then this iterative loop of multiplying (actually printed) money through the bank reserve ratio.
Multiplying Ratio = 1/(Reserve Ratio)
For example, if the reserve ratio is 10%, then the theoretically maximum amount of money that could be circulating on the market would be 10X that of the base.
Historically the actual realized multiplier was never that high though, as can be seen above. In fact, immediately after the Lehman shock, the multiplier dropped below 1X, meaning there is actually less money circulating than the actual monetary base (printed money). This is why despite the crazy quantitative easing (QE) by the Fed, neither the economy nor the inflation was really picking up as fast as was expected. Money were not being lent out or circulated as desired.
Also note that if everyone tries to naïvely withdraw all their money from the bank, there will not be enough money for that as long as the multiplier is larger than 1X, which is the normal situation. (The past 10 years have not, by any measure, been normal). This is what causes the so-called bank run.
However, given that the M1 Multiplier is hovering at around the pathetic 1X for many years, let’s take M1 as the actual money available to buy anything.
As seen above, the current US dollar M1 Money Stock is a about $3.788T. That seems to be a lot of money and can buy a lot of things. In fact, to the non-finance people, that should be the amount of the total values of everything you could buy in the country, intuitively, no?
Unfortunately, things could not be further from the truth.
For example, even if we do not eat, drink, live or move, this $3.788T is still not enough for us to buy all the stocks in S&P 500. As of 2019/3/31, the total market cap of S&P 500 is $24.76T. The total M1 Money Stock can only buy us about 15% of all the stocks in S&P 500 — and we have to sacrifice all other spendings that are more fundamental in our lives for this 15%.
So how can the total market cap of S&P 500 be worth so much more than all the money that’s out there? Because it’s a value that represents how much the market thinks all the future cash flows from these 500 corporates could generate is worth now. It’s a price that the market is willing to pay for owning these 500 corporates today. It’s a value and has little to do with actually how much money is out there.
Or think about it this way: let’s say we find a way to do bartering, i.e. exchanging goods/services for goods/services, as efficient enough as with a currency. The denomination of USD disappears. Money disappears. But the goods and services are still there. Human beings are still producing and consuming these goods and services. There is most certainly a value to them, even though we no longer have a reference such as USD to define it numerically.
This is why value is different from money, why the M1 Money Stock cannot afford to buy all the S&P 500 corporates out there, and why your Apple stock worth of $208 is different from $208 of cash in hand or $208 of deposit in the bank.
On the 3rd or 4th order, this is also the reason why judging a startup’s valuation based on whether it makes money or not, is at best misleading, at worst meaningless.