What Is Market Capitalization?
You may be a young person who has just come into a big raise or exciting new salary or a more seasoned working veteran who has come to the conclusion that you have to make your money work for you. The latter, by the way, seems to be a growing category.
Elsewhere I've explained why it is that our current fiat currency means that money-based saving cannot be treated as a reliable store of your wealth . So, whatever your motivations are, and personal circumstances aside, a decision to invest is wise.
If though you are just entering the investor's world, you will profit mightily from an understanding of how to leverage market capitalization. Previously (see the link at the bottom of this article) I analyzed the relevance and usefulness of market capitalization for informing investment decisions. Such insights, however, are premised upon a clear understanding of the concepts involved.
At the risk of stating the obvious, market capitalization is the value that the market attributes to the total capital of a business. More precisely, it is the value the market attributes to the equity of the business.
So, we first have to be clear about this term, equity. It refers to the total value of the company's assets (those things it owns) minus the company's liabilities (the things it owes to others). The final sum of these calculations is the company's equity.
An illustration: Begin with a hypothetical company, we'll call it XXX. Its total assets (e.g., real estate, equipment, patents) add up to a total of $10 million. On the other side of the ledger, XXX's total liabilities (e.g. bank debts, settlement in a legal challenge, pending regulatory compliance costs) add up to a total of $4 million. The equity of XXX is then determined by subtracting the $4 million liabilities from the $10 million assets, revealing equity of $6 million.
Already, though, a little backtracking is required. The value of those assets and liabilities, calculated to arrive at a valuation of equity, was in fact the value attributed to such items by the company. XXX's accountants do all these calculations based on prices stipulated in relevant contracts: documenting XXX's ownership and claims upon its property. The result of these processes is called the book value.
Smart accountants will of course amend those figures to take account of facts such as depreciation. If machinery has been used for many decades, basing its book value on the price when newly bought misrepresents the value it would have if XXX wanted to sell it to another company, today.
All of this, still, though only concerns book value. The market's valuing of that equity remains an entirely separate matter. Any correspondence between the book and market value of a company's equity is not to be expected. Indeed, experience suggests a divergence of those evaluations is the more likely expectation.
To distinguish between book and market value, let's begin with a brief statement of what market capitalization is and how it is determined. Prices of course emerge from markets as a function of subjective value. The totality of everyone's unique, personal preferences establishes the level of demand in relation to the existing supply.
In this context, companies issue shares, to raise investment funds. What sometimes is lost sight of is that after this initial issuance such shares are traded in market transactions as commodities. In this regard, they are no different than any other commodity, with complete independence of the original vendor, like any other commodity.
Think of a situation in which Mary sells an apple to Jane. Prior to the exchange Mary was the apple-holder. Following it Jane is the apple-holder. Mary may or may not have bought the apple from an apple farmer, but in either case none of the money that Jane pays Mary for the apple is owed to the farmer (unless, obviously, a prior, specific arrangement to that effect was struck by the farmer and Mary, but that's pretty much unheard of).
A company's shares are no different. The shareholder exclusively holds the share(s) as a function of a purchase from someone else who likewise had complete ownership. Nothing from the exchange is owed the company and the company has no immediate control over the selling or buying price. This is no different than in the apples example. Determining the price of an apple, though, is a complicated process taking much into account: people's subjective preferences will vary depending on many factors. This too is no different in arriving at the market valuation of a company's shares.
We now can understand how market capitalization is derived. There is at any point in time a market price for the shares of company XXX. To determine the market capitalization the total number of shares issued by the company is multiplied by this price. The resulting figure is XXX's market capitalization.
If our hypothetical company XXX has issued one million shares and the market value of them is going at $6 each, we know that the market capitalization of XXX is $6 million. By happy coincidence, this just happens to be the book value of the company as we hypothesized it was calculated by XXX's accountants.
Such elegant symmetry, alas, is rarely the situation in the real world. This recognition, though, opens up the discussion to a whole other dimension. Why and how the almost certain discrepancy between book and market value of a company's equity comes to be is vital knowledge for aspiring investors. This though leads us to a more elaborate discussion of market capitalization.
Elsewhere I've explained why it is that our current fiat currency means that money-based saving cannot be treated as a reliable store of your wealth . So, whatever your motivations are, and personal circumstances aside, a decision to invest is wise.
If though you are just entering the investor's world, you will profit mightily from an understanding of how to leverage market capitalization. Previously (see the link at the bottom of this article) I analyzed the relevance and usefulness of market capitalization for informing investment decisions. Such insights, however, are premised upon a clear understanding of the concepts involved.
At the risk of stating the obvious, market capitalization is the value that the market attributes to the total capital of a business. More precisely, it is the value the market attributes to the equity of the business.
So, we first have to be clear about this term, equity. It refers to the total value of the company's assets (those things it owns) minus the company's liabilities (the things it owes to others). The final sum of these calculations is the company's equity.
An illustration: Begin with a hypothetical company, we'll call it XXX. Its total assets (e.g., real estate, equipment, patents) add up to a total of $10 million. On the other side of the ledger, XXX's total liabilities (e.g. bank debts, settlement in a legal challenge, pending regulatory compliance costs) add up to a total of $4 million. The equity of XXX is then determined by subtracting the $4 million liabilities from the $10 million assets, revealing equity of $6 million.
Already, though, a little backtracking is required. The value of those assets and liabilities, calculated to arrive at a valuation of equity, was in fact the value attributed to such items by the company. XXX's accountants do all these calculations based on prices stipulated in relevant contracts: documenting XXX's ownership and claims upon its property. The result of these processes is called the book value.
Smart accountants will of course amend those figures to take account of facts such as depreciation. If machinery has been used for many decades, basing its book value on the price when newly bought misrepresents the value it would have if XXX wanted to sell it to another company, today.
All of this, still, though only concerns book value. The market's valuing of that equity remains an entirely separate matter. Any correspondence between the book and market value of a company's equity is not to be expected. Indeed, experience suggests a divergence of those evaluations is the more likely expectation.
To distinguish between book and market value, let's begin with a brief statement of what market capitalization is and how it is determined. Prices of course emerge from markets as a function of subjective value. The totality of everyone's unique, personal preferences establishes the level of demand in relation to the existing supply.
In this context, companies issue shares, to raise investment funds. What sometimes is lost sight of is that after this initial issuance such shares are traded in market transactions as commodities. In this regard, they are no different than any other commodity, with complete independence of the original vendor, like any other commodity.
Think of a situation in which Mary sells an apple to Jane. Prior to the exchange Mary was the apple-holder. Following it Jane is the apple-holder. Mary may or may not have bought the apple from an apple farmer, but in either case none of the money that Jane pays Mary for the apple is owed to the farmer (unless, obviously, a prior, specific arrangement to that effect was struck by the farmer and Mary, but that's pretty much unheard of).
A company's shares are no different. The shareholder exclusively holds the share(s) as a function of a purchase from someone else who likewise had complete ownership. Nothing from the exchange is owed the company and the company has no immediate control over the selling or buying price. This is no different than in the apples example. Determining the price of an apple, though, is a complicated process taking much into account: people's subjective preferences will vary depending on many factors. This too is no different in arriving at the market valuation of a company's shares.
We now can understand how market capitalization is derived. There is at any point in time a market price for the shares of company XXX. To determine the market capitalization the total number of shares issued by the company is multiplied by this price. The resulting figure is XXX's market capitalization.
If our hypothetical company XXX has issued one million shares and the market value of them is going at $6 each, we know that the market capitalization of XXX is $6 million. By happy coincidence, this just happens to be the book value of the company as we hypothesized it was calculated by XXX's accountants.
Such elegant symmetry, alas, is rarely the situation in the real world. This recognition, though, opens up the discussion to a whole other dimension. Why and how the almost certain discrepancy between book and market value of a company's equity comes to be is vital knowledge for aspiring investors. This though leads us to a more elaborate discussion of market capitalization.
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