When it comes to measuring business value, the stock market is not a ratio scale.
What does this mean and why should any investor care?
Well, the stock market is a scale we use to measure business value.
But what type of scale is it and what exactly does it measure?
There are 4 basic scales of measurement: the nominal, ordinal, interval, and ratio.
Each scale matches the 4 properties of an “abstract number system,” identity, magnitude, interval, and a true zero point, to a different degree.[1]
The 4 properties of an abstract number system are defined as follows:
“Identity means that each number has a particular meaning. Magnitude means that numbers have an inherent order from smaller to larger (5 is larger than 3). Equal intervals means that the difference between units is the same anywhere on the scale (the difference between 2 and 3 is the same as the difference between 99 and 100). The zero on the abstract number scale is a true zero. Because of these properties, we can add, subtract, multiple and divide the numbers.”[2]
A true zero means that if we are measuring distance and the scale reads zero it actually means we have gone nowhere.
The scale of measurement which matches the number system the least is the nominal scale.
It is a “naming scale” and only has the property of identity.
Some examples would be the location of the headquarters of a company (Chicago, New York, Dallas) or the company’s name (Boeing, Citigroup, ExxonMobil).
In each case you use a name to identify a place, thing, or collection of things that have a distinct meaning (Chicago is not the same as New York).
However, if you assigned the number 1 to Chicago and the number 2 to New York you couldn’t divide Chicago by New York and claim it was equal to .5.
Nominal scales of measurement are used to “classify” or “categorize” things but “have no zero point, cannot be ordered high to low, and make no assumptions about equal units of measurement.”[3]
Next is the ordinal scale.
Ordinal scales possess the properties of identity and magnitude: each thing measured is distinct from the others (identity) and also has a certain size which can be ordered from high to low (magnitude).
Ordinal scales provide information about “the relative order of magnitude (nominal scales do not), but they do not give us any information about the differences between the categories or the ranks.”[4]
An example is that of class standing.
You can rank students 1,2,3,4. That tells you that number 1 is ranked higher than 4 but you don’t know how wide the spreads are. Maybe 1 and 2 had GPA’s of 4.0 and 3.98 respectively or maybe the spread was 4.0 and 3.50. A simple class ranking is not enough to tell you. [5]
To get that information you must use an “interval scale” of measurement which has the properties of identity, magnitude, and equal intervals between measurement points (like the GPA numbers). [6]
Common examples of intervals scales are the temperature scales of Celsius and Fahrenheit: they measure something distinct, 100° is greater than 50°, and the intervals between the measurements are equal.
What’s missing?
A true zero: 0° Celsius does not mean there is no temperature (heat) at all.
A scale which has properties of identity, magnitude, interval, and true zero point is called a ratio scale.
It comes closest to matching a real number system and you can add, subtract, multiply, and divide the measurements and have it mean something because of the true zero point.[7]
Normally when you measure fundamental physical attributes like mass and distance you use a ratio scale.
For example, 100 miles is twice 50 miles and 0 miles means no distance has been traveled. The difference between miles 34 and 35 is the same as between miles 87 and 88.
So what type of scale is the stock market?
The important point for investors is that the stock market is not a ratio scale when it comes to measuring business value.
In other words, the stock market does not have a true zero point if business value is what you want to measure: if a company’s shares are selling at $0.00 that does not mean the under-lying business is worth nothing.
It may in fact be worth nothing or it may in fact be worth quite a bit.
The determination of business value depends on an examination of the financial statements of the company in question, which in fact are a ratio scale (if the cash account reads $0.00 it means there is no money in the bank).
But shares quoted on stock exchanges are not ratio scales when used to measure business value: assume shares of ExxonMobil stock stopped trading on the NYSE tomorrow and were not quoted on any exchange for the foreseeable future.
The “market value” of ExxonMobil would in fact be zero but the “business value” would remain exactly the same (all else being equal).
Over the long-run stock markets may reflect business values very accurately.
But that doesn’t mean they can or should be used to measure them.
[1] Anthony M. Graziano and Michael L. Raulin. Research Methods: A Process of Inquiry. 4th Edition. (Needham Heights, MA: Alyyn & Bacon, 2000), pp. 75-79.
[2] Ibid, 75.
[3] Ibid, 78.
[4] Ibid, 78.
[5] Ibid, 78-79.
[6] Ibid, 79.
[7] Ibid, 79-80.
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Whew, someone has had a little too much cafeine. You could have just siad - work hard, save your money, look for bargains, and don’t go investing your money in something you don’t understand! Also, before you buy stock - ask yourself some questions -
Do I use the products this company produces?
Are they looking to further the planet or destroy it ?
Do I have an allegiance to this company that I will stay with it no matter if the stock price dips a bit?
Will my investment in this company help myself and other individuals realize a better quality of life?
Sometimes, not always, this helps seperate the chaff from the wheat.