Supports: Microeconomics, Chapter 8, Macroeconomics, Chapter 6, and Money, Banking, and the Financial System, Chapter 6
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A firm’s initial public offering (IPO) is the first time it sell stock to the public. The total value of a firm’s outstanding shares of stock is called the firm’s market capitalization, or market cap. According to an article in the Wall Street Journal, the AI firm Anthropic was expecting that the price of the stock in its IPO would result in the firm having a market cap of $1.5 trillion. Before a firm can undertake an IPO it must file an S1 form with the Securities and Exchange Commission, disclosing all the information that would be relevant to investors who are considering buying the firm’s stock. In its S1, Anthropic noted that, although in the previous quarter it had revenue of $17.0 billion, it had suffered a net loss of $23.3 billion.
Explain how a firm that is losing billions of dollars can have a market cap of $1.5 trillion.
Solving the Problem
Step 1: Review the chapter material. This problem is about how investors value a firm’s stock, so you may want to review Microeconomics, Chapter 8, “The Fluctuating Stock Market,” (Macroeconomics, Chapter 6) or the more complete discussion in Money, Banking, and the Financial System, Chapter 6, “The Fundamental Value of Stock.”
Step 2: Answer the question by explaining how investors value a firm’s stock. Ownership of a firm’s stock represents a claim on the firm’s profits. So we would expect that the larger a firm’s profits are, the higher the firm’s stock price (and market cap) will be. But a key point is that investors’ demand for a firm’s stock is based less on the current profitability of a firm than on the firm’s expected future profitability. If you own a stock in a profitable firm, the firm will pay you dividends. Therefore, the fundamental value of a share of stock is equal to the present value of the dividends to be received from owning that share. (We show the arithmetic of valuing stocks in Chapter 6 of Money, Banking, and the Financial System.)
Anthropic was expecting to be able to price its IPO to give the firm a market cap of $1.5 trillion despite currently experiencing billions of dollars in losses. We can conclude that investors must be expecting the firm to earn enough profits in the future to justify that high valuation. Of course, investors’ expectations could be wrong (they frequently are!) and Anthropic may never earn profits high enough to justify its IPO price.
