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"Marked to Market": What Does It Mean? By Stephen J. Butler

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You may have seen or heard the phrase: "marked to market."

This little phrase tells you a lot about the entire process by which the stock market prices individual shares each trading day.

To explain marked to market, I'm going to tell a story about a hypothetical new house, a lawn mower, and your brother-in-law.

First, though, some background. The value of all stock is based upon shares that actually trade on any given day. For most large public companies, this is a miniscule fraction -- far less than one percent -- of all shares outstanding.

Yet, when this tiny amount changes hands, the last transaction of the day is listed as the day's closing price. That determines the value of ALL shares of that stock -- wherever they might be owned. This end-of-the-day price is what you see quoted for, say, General Electric when you look in the newspaper the following morning.

The term used to describe this practice is "marking the stock to market." It refers to the practice of valuing all company stock at the same price as the most recent trades.

There is an inherent fallacy in this practice. To illustrate, let's say you buy a new home for $250,000. It is a builder's showcase that comes with furniture and a riding lawn mower. The lawn mower is considered to be worth $250 (1/10th of one percent of the total home price).

You sell the lawn mower to your unsuspecting brother-in-law a month later for $500, because he has been looking for that model and can't find it anywhere else.

If you were marking to market, you would suddenly have created a $500,000 house and a $250,000 profit. That's because all company stock is valued on the basis of whatever piece sells today - in this case, the $500 lawn mower.

By comparison, a private company owned by individuals and not traded on any stock market could only be valued based on an outside appraisal of ALL of its assets. The true value of a company, in theory, is what a willing buyer would pay a willing seller for the whole thing.

Marking to market is the magic potion by which wealth gets created in the public markets. To demonstrate this, I'm going to take you through a lot of numbers, but stick with me:

Three people with a product idea invest $150,000 and start a company. They talk a venture capital firm into investing $2 million in return for 20% of the company. The founders still own 80%. A second round of venture capital generates $10 million in exchange for 10% of the company, and the founders still own 70%.

Next, the company "goes public" and sells 20% of the company in an initial public offering (IPO) that raises $30 million. The three founders still have 50%. Since the public's $30 million is one-fifth (20%) of the whole, the entire company is valued at $150 million.

The three founders, with 50% ownership, are now worth $75 million, because their stock is valued at the same price as that of the most recently traded shares. If the stock doubles after the IPO, the entire company is worth $300 million and the founders' stock is worth half that, or $150 million. The first venture capitalists who invested $2 million for 20%, now have a position worth $60 million (because the post-IPO market price has doubled). The second VC's, with their $10 million investment, now have $30 million.

Back in the industrial park nothing has changed. The total invested capital is only $42,150,000. What has happened to suddenly make this company worth $300 million dollars and its three founders worth $150 million dollars? This wealth (as opposed to value) is based only on the intense demand for the few shares that were available for trading.

Some of you might say, "So what? My investments have doubled in value in the last five years. I could sell them today based on the value of today's trading prices. What do I care if one day's trading prices create the value of my assets?"

The answer is that the lawn mower's price can change dramatically - up OR down. Your brother-in-law, who said he would send a check, suddenly finds out that he can buy a brand-new mower at Sears on sale for $125 and that's all he will pay for yours. Your house, based on the latest trade of a 1/10th percent piece of the deal, just dropped in value to $125,000.

What's the overall lesson of marked to market? Appreciate the fragile, ephemeral nature of stock values. Warren Buffet says that stock prices rarely reflect the true value of companies. When it does happen, its an accident. Instead, our stock prices depend on daily-valued future expectations of traders coupled with the particular supply and demand of stock on a given day. A diversified investment portfolio should be anchored by stocks, but it should also include bonds, cash, and equity in a home for a complete mix of investment types.

BUYandHOLD does not offer or provide any investment advice or opinion regarding the nature, potential, value, suitability or profitability of any particular security, portfolio of securities, transaction or investment strategy. Any investment decisions you make will be based solely on your evaluation of your financial circumstances, investment objectives, risk tolerance, and liquidity needs. The securities mentioned above are being used for illustrative purposes only and should not be regarded as an offer to sell or as a solicitation of an offer to buy and past performance is no guarantee of future results.