In partnership with

If you ever want to make an economist mad, you’ll have a lot of options, but a favorite of mine is comparing someone's net worth to the GDP of a small country. Sure, these numbers are both quoted in dollars, with increments in billions. But, as the economist will certainly point out, that's all they have in common: net worth is equal to cash plus the present value of future cash flows from assets they own (typically best estimated by looking at the market value of those assets), and GDP represents the total value of all goods and services produced within a country in a given year—these are very different things! If there were a market for slices of countries' future GDPs, or of their taxes, then such a comparison could work, but it's otherwise a nonsense comparison, like saying that a particular novel has more words than a symphony has notes.

The specific issue economists will point to is that you're comparing stocks to flows (economists often use jargon that has a completely different meaning in business, perhaps as part of some conspiracy by Big Academia to make it harder for them to get private-sector jobs). Briefly: a flow is any change over time, and a stock is the accumulation of flows. So your refrigerator's stock of food is fairly constant over time, but this consists of flows in when you shop, and flows out when you eat. The value of a business (the stock) is the value of existing assets plus future free cash flows.¹ But wait! That value is mostly the sum of the future flows! We're comparing stocks to flows all the time. In fact, since financial asset turnover is far higher than GDP (i.e. the sum of the value of all stocks, bonds, currencies, etc. traded in a given year is much higher than the total amount of economic activity), then by gross dollars involved, comparing stocks to flows is overwhelming majority of economic activity.

But it still needs to be done judiciously. Over sufficiently long periods, most of the movement in stock prices is driven by revenue per share (in a DuPont formula-style analysis, it's the variable whose rise is unbounded; margins, asset turnover, multiple, etc. can't rise forever the way sales theoretically can). But over short periods, changes in the multiple dominate; it's hard for a company to increase its intrinsic value by 1% in a single day, but stock prices fluctuate by that much all the time. In other words, all that activity converting flows into stocks is predicated on the fact that it's hard to do it right and the conversion rate” is constantly up for debate.

This raises some fun questions, because some kinds of income are in a suspicious “partly a stock and partly a flow” intermediate zone. Consider this popular argument from back in 2015 about how the fifteen best-paid hedge fund managers make more than all of the country's kindergarten teachers put together.² The trick here is that some of that fund manager income is from management and performance fees, and some of it is from capital appreciation, which also drives those performance fees. But that capital appreciation is a change in the market's assessment of the value of future flows, which is not quite a flow itself.

Whether capital appreciation is better thought of as reassessing a stock or accumulating a flow is a tough question, which probably comes down to whether the activity that leads to that capital appreciation is repeatable and human-limited, or is not-necessarily-repeatable and capital-limited. For example, making a market is closer to a job than an investment, but buying a passive portfolio is very much an investment—you're getting paid to deal with volatility and the passage of time, not for any special effort it took you to click the "buy" button. In any given year, some of the best-performing hedge fund managers will be the ones who are grinding out a bit of uncorrelated alpha each month. But some of them will be investors whose five-year track record looks something like this: +8%, -5%, +9%, -11%, +152%. In other words, they're running a strategy with power law returns; in most years, performance is nothing to write home about, but sometimes they get something really, really right. In that case, the "flow" of their income is probably best approximated by compounded returns, not by peak returns, since in any given year there will be different funds that achieve those peak returns. Another way of looking at this is that the cohort of "top 15 hedge fund managers" is not necessarily stable from year to year, and the names that do appear frequently are from people who've accumulated a lot of capital and are growing it gradually but inexorably.

This continuum also shows up in company metrics. Many companies report some kind of engagement number, and over time those numbers have gotten increasingly precise: MySpace talked about its total registered user count (a stock), while early Facebook talked up its weekly active user numbers; WAUs are equal to or lower than registered users by definition, and they're a harder number to pump up, but if one company is growing them and another isn't, the former is eventually going to win if that trend persists. Now, it's increasingly common for companies to talk about daily active users, and sometimes to give engagement metrics like time spent. These more precise metrics are flowier than the previous iteration (a weekly active user number is mostly a flow, but compared to a daily number it's stockier—it's the cumulative number of unique users who logged in in the past, albeit the very recent past, and one trend it can obscure is when users keep responding to the occasional push notification but no longer check a particular app first- and last-thing each day). This change has even migrated to user interfaces, which increasingly show the number of concurrent viewers in addition to the total number of views for a piece of video content or article.

So the stocks-versus-flows distinction remains very important, and it's easy to look at an unfamiliar one-time or cumulative number and erroneously compare it to a continuous quantity. But people can, and do, compare stocks to flows all the time. Financial systems are a continuous attempt to reshuffle assets towards the people who can manage them best or who are most tolerant of whatever their particular risk/reward payoff functions are, and that means constantly examining flows in order to determine their present value, and speculating about how that present value might change, or might be valued more highly, by someone else.

Rise and grind, dollar bills!

Put your money to work in a high-yield cash account with up to $2M in FDIC† insurance through program banks.

Get started today, with as little as $10.

Read More in The Diff

The Diff has implicitly explored the stocks/flows boundary in a few places:

• We’ve looked at how some industries shift back and forth between being asset-light and asset-heavy ($).

• We’ve also specifically examined the economics of aircraft leasing companies, which sometimes get valued based on cash flow and sometimes based on their balance sheets ($).

• Want to read more about situations where capital gains are economically wage income rather than a return from deploying capital? Look no further than this profile of Jane Street.

• We’ve also looked at the question of where returns come from, and what investors should do when future flows are low compared to current prices ($).

1. Often, but not always, the implicit assumption is that the business will be around long enough that all of these assets will depreciate to zero, and be replaced, and that depreciation will, over time, roughly correspond to maintenance capital expenditures that come out of free cash flow. So we're not double-counting when we add up assets and future cash flows. We would be undercounting if we ignored the company’s existing assets; a company in an obsolete industry, but which bought some valuable real estate in more flush times, will end up being valued mostly based on the assets on its balance sheet.

2. This was, just in rhetorical terms, an absolutely brilliant piece of work. Specifying "Kindergarten" simultaneously makes it more specific/evocative and means you're talking about a smaller amount of income. Of course, roughly nobody has any sense of what the total wages of kindergarten teachers in the US are, so nobody has any cached information about whether or not this is a big number—but people do generally have positive feelings about kindergarten teachers, and negative-to-neutral ones about hedge fund managers, so that's what they fixate on. All in all, a really effective line. It's Linda the bank teller, squared!

Join the discussion!