Average FTSE growth vs GDP growth

benbay001

Why does the FTSE grow on average 7% (figure from the top of my head)
When GDP growth of 2% is considered more normal?
Or is this just a case of me being young and having not experienced times of rapid growth to adjust the averages?


In my head, as a long term average, Market Growth should = GDP growth.


Of course the FTSE contains many international businesses, but I don't believe this accounts for the difference.

bowlhead99

The two things have a different basis and are measuring different things.

Simplistically, the value you would place on a share of a company is the present value (with a suitable discount rate) of all the money you're going to get from owning it in the future: its profits, which as an owner of the company, you own. There are a range of valuation techniques which for some company types may include an assessment of assets rather than purely the profit rates.

GDP is the gross domestic product: the total output of a country.

So imagine the whole economy was one company making widgets or selling services and they increased their sales from £100 to £102. You would say GDP measured on the output method had grown by 2%.

Then look at it from a shareholder's perspective. The company makes £102 of sales but its fixed costs of operations haven't necessarily changed by the same amount. To make sales of £102 instead of £100 it now costs £91 instead of £90, so the profits go up from £10 to £11. So profits, on which the company's stock market valuation is measured, are up by 10%.

Let's consider a different company. This company's value is being measured by investors on an assets basis instead of an annual profits basis. At the beginning of the year this company (different to the one we looked at above) currently owns £100 of assets and it funded its total assets 50:50 by shareholder capital and bonds/loans/bank finance. Every year it makes a turnover of £502 and has £500 costs, making £2 of profit.

At the end of the year then, before divvying up the profit it has £102 of assets. The people owning the bonds or loans or bank finance will be happy for the company to give them a fixed rate of interest, say that's 1% of the £50 they put in (£0.5). That gets paid out the door to the lenders as an annual interest charge and the company still has £101.5 of assets remaining. We know that £50 is funded by the bondholders/ lenders who will eventually want to get paid back their £50. So of the £101.5 of assets, the owners of the equity shares will only get £51.5. But at the beginning of the year they only had £50 of assets attributable to them. So over the year their share of the assets went up by 3% even though the revenue and profits of the company perhaps didn't change at all (it always makes £2 profits, and £1.50 after interest payments, on its annual £502 turnover).

So there are 'gearing' effects when looking at the returns made by equity shareholders, when you are comparing a rate of change of profits to a rate of change of turnover, or when you are comparing a rate of growth of geared assets they own to a rate of change of profits or turnover.

As such, you can see that even for a 1-company economy, the GDP measurement will differ from a stock market valuation measurement.

We would perhaps expect the two measures to be correlated (move in the same direction) but not move by the same amounts - and in the real world it doesn't even move in the same direction all the time because markets are fickle and based on opinion and sentiment of the future direction things will go. For example a GDP growth of 2% after inflation may not translate to any stock market growth at all (other than the inflation element) because the GDP growth was exactly as expected and the people setting the market prices of companies had already anticipated that the GDP growth was going to be 2% when working out what they would pay to buy the company, and they are happy that the price is fine and doesn't need to change.

You mention that the FTSE contains international businesses. Comparing company output to stockmarket value is easy in a fictional world which is a nice closed loop with everything happening in that economy. It gets a lot more complicated when the company whose market value is being measured is carrying on activity in a whole bunch of other economies elsewhere. So this stuff isn't straightforward.

Another point about the basis of measurement is that the economy whose GDP is being measured is not solely constituted by stock market listed companies with a profit motive. When you look at the ONS statistics for the preliminary GDP estimates [http://www.ons.gov.uk/ons/guide-method/method-quality/specific/economy/output-approach-to-gdp/methods-and-sources/creating-the-preliminary-estimate-of-gdp.pdf] you can see that about 20% of the GDP comes from the 'government' sector. While government might employ a whole load of civil servants and teachers and refuse collection engineers and healthcare providers, whose output or consumption can be quantified in financial terms - it is not the same kind of productiveness that fuels the stock market prices.

So if an overall economy's 'product' grows by 2%, that might be because the 80% of the economy which is commercial revenues going up by 2.5% in real terms, plus the 20% of public sector output going up 0%. In some parts of the world, a lot more of the economy is public sector than others.

Similarly, when introducing public vs private sector I said above that GDP wasn't just about stock market listed companies with a profit motive. But stock market performance is: it's specifically stock market listed companies.

Your auntie might have a little self-employed business going on, where she embroiders doilies and sells them on ebay for a small profit, or your uncle owns a fleet of taxi firms which just about break even over the year but it's enough to pay him a small return, or Philip Green owns a failing business empire including Topshop and BHS; all of these things should somehow factor into the country's GDP on an output measure or a consumption measure. However, only at a certain scale and size and proven or prospective level of profits will a business look to attract external equity capital by being listed on a stock exchange.

So the companies delivering profits and growth on a stock exchange might be expected to be more successful than the average of all business in the economy.

Of course it is more complicated than that because there are some tremendously successful privately owned businesses, and private-equity firms make a living from investing into venture-capital and buyout opportunities. But you can see how GDP growth differs from stock market growth when the GDP includes the national health service and people fixing holes in the road and a guy with a failing corner shop that he operates as a hobby for a sense of self-worth, while the stockmarket growth includes Microsoft, Apple, Netflix etc.

There is a great deal more to it than the few examples above, but this post is long enough

benbay001

That's one hell of a reply.
After a couple of re reads it makes sense.


A big thank you for your time.

Joe_Bloggs

Many thanks to Bowlhead for the illustration of a complex topic and the time and expertise it took to create.


I respectfully ask how does the numerical value of the FTSE indices trend with the value of Sterling.? What currency is employed for the valuation of multinational shares in this index?


When I was invested, if the pound crashed then the value of my holdings soared.


J_B.

Thrugelmir

benbay001 wrote: »

Why does the FTSE grow on average 7% (figure from the top of my head)

Over what time frame?

Linton

Joe_Bloggs wrote: »

Many thanks to Bowlhead for the illustration of a complex topic and the time and expertise it took to create.


I respectfully ask how does the numerical value of the FTSE indices trend with the value of Sterling.? What currency is employed for the valuation of multinational shares in this index?


When I was invested, if the pound crashed then the value of my holdings soared.


J_B.

The FTSE100 is is largely driven by a comparatively small number of very large companies such as HSBC, Shell, Rio Tinto , BP Et al. These companies do the greater part of their business outside the UK. The reason why they are listed in London is mainly historical, they could just as well be listed in New York or any other major exchange. It doesn’t actually matter as market trading is now global.

As the price of these companies is set globally it must correspond to the price of equivalent companies across the world. So they are priced in a weighted average of all the worlds currencies. When the £ falls against the other world currencies their price in £s must increase, and so the FTSE100 rises.

The implication of this is that if you want to invest in the UK the FTSE100 is not a very effective way of doing it. You need to look at smaller companies which do more of their business in the UK and are of less interest to global investors.

shinytop

Great thread; now I can appear really intelligent if somebody ask me this.;)

bowlhead99

shinytop wrote: »

Great thread; now I can appear really intelligent if somebody ask me this.;)

Unfortunately, most people will not ask you this