Glamorous market valuations end up in financial crisis

We are passing through trying times. It would still be advisable to examine to examine the anatomy of the present financial crisis which is largely payment related. The intrinsic values of the economy are by and large intact. Fancy valuations only have disappeared.

Why the present crisis? People spend more than they earn. Greed prompts them to act irrationally. In simple words, people create less value than they consume. For excess consumption they become indebted. To hide indebtedness, they inflate values of their holdings.

Let us see how it works in practice. For examples, you consume a value of Rs 100 for which you are funded by a bank, and you produce a product or services really worth Rs 80. You are in loss. However, if this product is artificially valued at the Rs 100, you are not in a loss. You are aided and abated in this process by the market in establishing the value of that product at Rs 100. When you are a country doing this, you are funded by other countries. If you are an individual or a corporation you are more likely to be funded by domestic banks or financial institutions. In all these cases, you are consuming values created by others.

How the markets help you in this process? When people start trading among themselves in an item, especially when funded by others, they indulge in excessive trading. The prices become artificial and financiers sat believing that the prices represent values which is often far from the reality.

The charade goes on till one day when the financiers lose steam. Reality starts dawning on the financiers and on the people who hold these assets with borrowed funds. Prices start falling to their realistic levels. Lenders get panicky forcing recoveries which set in motion the reverse process: people start selling to meet liabilities which push the prices further down.

You can see that this is likely to punish the innocent. For example, you are a salaried man. You create value by rendering a service. You have savings which represent your unspent value. You finance another person’s acquisitions of shares at a price which is excessive. When the price of the share falls, you also suffer if your borrower does not repay.

At macro level, somewhere values are created and somewhere they are destroyed. When destroyers default in repayment, the loss is transferred to those who created the values. This is highly unjust as the system favors those who destroy values over those who create values.

There is a special tactic by which corporations artificially create values. We can observe that corporations place more emphasis on the market share of products than on the bottom line. Even the special valuation models are designed to value corporations on the basis of their market share of products and not on the basis of their earnings.

It is believed mythically that the market share is all that should matter and later the market share alone would lead to improved bottom line. For the present, the bottom line is ignored. Nobody pays attention to the value addition achieved by corporations.

Based on the market share of a product, brands are created and valued at phenomenal figures. It defies all classical theories if financial management that any valuation cannot ignore the cash generation capacity of a corporation. Corporations that consume more values than they produce are also valued at phenomenal figures based on their so called market share. Such valuations are more glamorous than substantive.

Once brands are valued they are traded like a commodity, either directly or through the price of the shares of their companies. This trade is aided by financial institutions a