X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2018 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
Capital, Profits and Cash - Outside View by Nitin Gregory
  • MyStocks

MEMBER'S LOGINX

     
Login Failure
   
     
   
     
 
 
 
(Please do not use this option on a public machine)
 
     
 
 
 
  Sign Up | Forgot Password?  

Capital, Profits and Cash
Nov 30, 2015

'You must spend money to make money' - Plautus

Capital is one of the key factors of production; in previous discussions, we looked at how capital interacts with other factors to generate growth. Israel Kirzner, in An Essay on Capital, defines capital goods as way stations in someone's plan to produce consumer goods.

For example, the dusty moped in your garage has no (low) value to you. The newspaper boy who bought the moped from you values it higher, because he can expand his newspaper delivery route. The moped has become a part of his plan to provide a service and has a tangible value from his perspective.

In this discussion, we will delve further into how capital is converted to profits and cash. The key actors in the process are capitalists, entrepreneurs, and consumers. These are not necessarily separate entities. The same person assumes the role of a capitalist, entrepreneur, or consumer based on the context. When you put your money in a bank fixed deposit, you are acting as a capitalist. In buying a plot of land near an upcoming metro, you are acting as an entrepreneur. And when you buy the latest smart phone, you act as a consumer.

Where does capital come from? Savings are the source for capital. Savings by themselves do not aid production. A capitalist (owner of capital) delays current consumption and is ready to lend this money to the economy. 'Interest' is the compensation required by the capitalist to sacrifice current consumption. Interest rates have been identified a key signal for directing capital in a previous discussion.

An entrepreneur helps deploy capital in the face of uncertainty. He helps detect changes in consumer preferences and takes a risky bet in fulfilling them. The coming festive season means an increased demand for sweets - an entrepreneur puts his savings on the line to make a special kind of sweet. This helps him advantage from the change in consumer preferences and profit during this temporary demand spike. This is a small scale example of entrepreneurship.

Similarly, the unicorns (start-ups with billion dollar valuations) represent entrepreneurs who are expecting a shift in consumer preferences and are positioning themselves to profit. The valuations are driven by the expectations of profits in the future. Returns that match the interest rate (cost of lending) are not attractive. The increased risk taken by the entrepreneur has to be compensated by entrepreneurial profits.

Gene Callahan in Economics for Real People describes capital as a coral reef structure. The corals are all connected. The corals below the surface represent the second order goods (used to produce something), and the corals at the surface represent consumer goods.

Further, the waves are likened to changing consumer preferences. The corals at the surface are constantly in flux, which represents the fickle nature of consumer demand. Stronger waves will affect the coral reef more fundamentally, like a major technology change.

Entrepreneurs seeking profits are the key actors who help shape this coral reef structure. They anticipate changes and invest capital in the hope of fulfilling this new demand. A business that has the capability to anticipate and fulfill change can be a compounding machine over time.

Entrepreneurial profits and losses cannot continue indefinitely. Usually either competition enters to take away the surplus or the enterprise has to fold. Entrepreneurs try different methods to help defend the productivity of their capital.

'In business, I look for economic castles protected by unbreachable 'moats'.' -Warren Buffett.

Warren Buffett talks about this with an analogy on castles and moats. Every business can be viewed as a medieval castle surrounded by a moat to protect from attackers (competition). The moat can be of different things, such as brand, IP, size, etc...

The bigger the moat, the longer a business can sustain entrepreneurial profits. The entrepreneur from our previous sweets related example can have a longer period of profits if nobody else is able to guess the recipe of his special sweet.

A great business is able to deploy capital to satisfy the changing demands of the consumer and also earn a profit after accounting for all costs (including the cost of capital). A common measure used to measure this is economic value added.

What is the best way to value capital? If capital is defined by its use in fulfilling demand, how can an investor determine its value? Is it just the cost of procuring capital? We will attempt to answer these questions in a later discussion...

This column is authored by Nitin Gregory. Nitin, who graduated from IIM-Calcutta, is currently pursuing a finance role with an automotive major. He has a deep interest in Macroeconomics and pens a blog at Gregonomics.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

Equitymaster requests your view! Post a comment on "Capital, Profits and Cash". Click here!

  

More Views on News

What They Forgot to Tell You About Sensex at One Lakh (Smart Contrarian)

Nov 29, 2017

Stocks that could beat Sensex returns in the long term.

How to Ride Alongside India's Best Fund Managers (The 5 Minute Wrapup)

Jun 10, 2017

Forty Indian investing gurus, as worthy of imitation as the legendary Peter Lynch, can help you get rich in the stock market.

The Technological Marvel That is Ethereum (Outside View)

Feb 23, 2018

Have you been wondering what the hoopla about Ethereum is? It commands the second highest value among virtual currencies and its popularity is rivalled only by bitcoin. Let's break it down.

A New Quest for the Stock Market's MOST Profitable Ideas... (Smart Contrarian)

Feb 23, 2018

If you want to receive the best ideas in the Indian stick markets...you need to heed this important announcement.

Ramesh Damani is Bullish on Niche IT Stocks and I've Found One for You (The 5 Minute Wrapup)

Feb 23, 2018

This IT Company can be a huge wealth Creator for Smart Money Secret's Subscribers.

More Views on News

Most Popular

The Foundation for Sensex 100,000 is Laid(The 5 Minute Wrapup)

Feb 17, 2018

Top three reasons for Tanushree's presentation at Equitymaster Conference to be centered around a possible 30% correction.

India's Rs 1,66,276 Crore Problem(Vivek Kaul's Diary)

Feb 15, 2018

That's the loss, the government owned public sector enterprises are expected to make this year.

The Big Gamble(The Honest Truth)

Feb 15, 2018

Once you accept the fact that elections are round the corner and that this budget is geared to reach a 40% target, everything makes sense.

How I Beat the Index by 2x... And Why I Believe This Could Happen Again(Smart Contrarian)

Feb 12, 2018

Will Microcap Millionaires be able to replicate its past performance of beating the index by 2x?

NPAs Set to Rise Further with New RBI Rules(Chart Of The Day)

Feb 15, 2018

The RBI overhauls bad loan framework. Banks may come under additional pressure due to rising NPAs and increased provisioning.

More

Small Investments
BIG Returns

Zero To Millions Guide 2018
Get our special report, Zero To Millions
(2018 Edition) Now!
We will never sell or rent your email id.
Please read our Terms

S&P BSE SENSEX


Feb 23, 2018 (Close)

MARKET STATS