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I never tried to trade stock myself, so my question might be stupid.

Say each of company A and company B is worth $1M at the beginning. Then each company divides themselves to 100 shares. And in some way, let company A own 99 shares of company B, and company B own 99 shares of company A. It seems that in theory someone can still buy both whole companies using only $2M.

But that would mean the 1 other share of company A is worth $1M, and buying it means you own 50.251 of company A and 49.749 of company B directly and indirectly. (Same goes to company B.) And the 100 shares are worth $100M? If someone is going to buy them, they will own most of their own $100M indirectly under company B, though.

So my questions are:

  1. Did I make some wrong assumptions here?
  2. If not, does this have a significant effect in reality?
  3. If no, what prevented it being significant, and if yes, how does the parameters involving market capitalization still make sense?

Edit: My naive hypothetical way getting into this situation, scaled the shares up to 10k times:

  1. Initially, Each company has 10k shares. Company B has $500k money and possibly other assets.
  2. Company A issued 5k new shares, which gives it $500k money.
  3. Maybe the stock price of company A goes too low, but anyway company B bought those 5k shares using $500k money. Let's say company B in fact invested in something else, where their money is actually used to buy the shares of company A, so they aren't aware the following is happening.
  4. Company B does the same thing, issuing 5k shares for $500k money. Company A bought those 5k shares using the $500k it just got.
  5. Repeat this process 198 times. So each of A and B has 1M shares, and 995k of them are owned by each other, maybe indirectly. But their market capitalizations skyrocket anyway.

The problem I see is if it can be manipulated this way, it doesn't seem to make sense to take market capitalization, assets in the form of stock shares, or other affected things seriously in investments.

Edit 2:

I was stupid. Searching this term in my first language, the first result defined it as a kind of bubble in the first paragraph. I'm not sure why Wikipedia only says it is "wasting capital that could be used to improve productivity", as the capital either comes from nowhere or is freed thereafter to allow them to invest in other things or back again. And by googling I found at least one source (which I'm not bothered to find out what it is basically about yet) mentioned it has adjusted the market capitalization according to cross ownership. But I don't think I'm qualified enough to give a complete answer.

  • Companies can own other companies in whole or in part, but somewhere in the hierarchy you need one or more people to own shares. Your example seems to lack any people, which makes it confusing what your scenario is. – user32479 Dec 9 '15 at 0:40
  • @Brick The 1 share not owned by the other company should be owned by people. – user23013 Dec 9 '15 at 0:43
  • How much did this phenomenon contribute to the amazing enterprise values that were quoted during the Volkswagen / Porsche takeover battle? – Jasper Dec 9 '15 at 0:45
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    This is an hypothetical question. It is impossible to reach such configuration in a Public Listed company. In Private companies, this is possible but would serve no purpose. – Dheer Dec 9 '15 at 3:27
  • @Dheer Would it be more on topic on Economics.se? – user23013 Dec 9 '15 at 4:56
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I started to work out, step by step, why this doesn't work, but the scenario is too convoluted to make that helpful. Basically, you're making mistakes in some or all of the following spots:

  • You are ignoring the fact that no outside money is coming into the system. This means that the fundamental value of the two companies is not changing.
  • You seem to be ignoring that each company is spending its cash on hand to buy shares of the other. On each company's books, when they purchase shares they are getting an increase in value due to a increase is assets (stock in the other company) but they are also getting a decrease in value due to the outflow of cash. In the "first round" of your scenario, these should cancel each other out in net value. In the later rounds, you would need to work out a sensible value of the shares to compute the assets held by each company. See next bullet, but at a sensible value, the same basic thing should happen.
  • Because the value of the companies is not changing and the number of shares is increasing, the true value per share has to be decreasing. You've assumed throughout that the companies can keep issuing shares at the same price in each round. You could take two perspectives on this assumption: Either (1) It's not realistic and this is what creates the artificially high apparent capitalization that seems to concern you, or (2) The capitalization in of these specific companies has become inflated (there's some sort of "bubble") and you shouldn't trust it.
  • For the first two points, I was aware that it doesn't generate money. I understand your last point as, there are no technical rules disallowing that, but the investors would be aware of this themselves and would not let it happen (at least not that many rounds). Is that the case? – user23013 Dec 9 '15 at 15:52
  • As @Dheer pointed out, public companies are regulated. This is obscure enough, that I'm not clear if those rules would prevent this or not, and it might depend on which state's / country's rules apply. One might hope rules would either prevent it or require enough disclosure that it could be accurately priced by the market, in which case your assumption that A & B can keep issuing shares ad infinitum at the same price is bad. A private company has some latitude to set the share price in many cases. Your scenario here is a very complicated way for them to do an inconsistent or poor job of it. – user32479 Dec 9 '15 at 16:39
  • As for the public/private distinction, in the US at least there are scenarios where a private company will get regulatory scrutiny too. The one that comes to mind that I've heard of: Employee-owned companies are private, but if the employer wants to allow employees to hold their shares in a 401k plan, that brings requirements to have the share price externally validated. Definitely would hope in that case, that the external agent would detect this situation and raise a flag even on a private company. – user32479 Dec 9 '15 at 16:50
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Initially, Each company has 10k shares. Company B has $500k money and possibly other assets.

Every company has stated purpose. It can't randomly buy shares in some other firm.

Company A issued 5k new shares, which gives it $500k money.

Listed companies can't make private placements without regulatory approvals. They have to put this in open market via Public issue or rights issue.

Company B does the same thing, issuing 5k shares for $500k money. Company A bought those 5k shares using the $500k it just got

There is no logical reason for shareholder of Company B to raise 5K from Company A for the said consideration. This would have to increase.

  • Maybe company B bought them back from the public. And company A invested in something else first, but then think company B is worth more? And I thought the answer should be, cross holding can happen, but it can be prevented before reaching such a ridiculous situation, or before having significant effects in the market. But your answer seemed to be disallowing cross holding all together? – user23013 Dec 9 '15 at 6:53
  • And as suggested in the comments to this question, intuitively a takeover seemed to be a valid purpose to buy shares for both companies, if not regulated by more complicated rules. – user23013 Dec 9 '15 at 6:59
  • He also never specified that the companies are public. Private companies can and do issues shares. – user32479 Dec 9 '15 at 11:40
  • @Brick agreed. That's precisely my comment on the question. – Dheer Dec 9 '15 at 13:01
  • @Dheer Then I'm confused by why you think your answer is germane since the first two points are entirely based on regulatory restrictions. (I also don't necessarily think that these restrictions are accurate, but that's probably beside the point - And more work that I'm personally willing to put in on such a convoluted hypothetical question. It also may depend, of course, on the jurisdiction where this hypothetical occurs.) – user32479 Dec 9 '15 at 14:19

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