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Capital, Profits and Cash - Outside View by Nitin Gregory

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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.

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