Understanding 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.
I've demonstrated elsewhere that under the conditions of fiat currency, money-based saving cannot be treated as a reliable store of your wealth . So, whatever the reasons behind your choice, choosing to invest is a wise decision.
Starting down the investor's path, a valuable bit of knowledge is how you can leverage market capitalization in your decisions. Previously (see the link at the bottom of this article) I have discussed its relevance and usefulness for informing investment decision making. Before those insights can be utilized, though, our terms have to be defined.
Just as it sounds, market capitalization invokes the total value that the market attributes to a company's capital. This value attribution, as we'll see, derives from the pricing of the company's shares. More precisely, the idea of market capitalization captures the market's valuation of a company's equity.
Equity is derived from adding together the total value of the assets (things owned by the company) and the subtracting from that number the total value of the liabilities (things owed by the company). A resulting positive number is the equity.
For instance, a hypothetical company, call it XXX, has total assets (e.g., real estate, equipment, patents) of $10 million. Its total liabilities (e.g. bank debts, settlement in a court case, pending regulatory compliance costs) add up to $4 million. The equity of XXX is calculated by subtracting the $4 million liabilities from the $10 million assets. The equity of the company is thereby established as $6 million.
Before going any further, however, an important qualification needs to be addressed. In our example of company XXX, the value of assets and liabilities, which were calculated to determine equity, was the valuation by XXX of its own equity. XXX's accountants did the calculations. Their beginning point was likely the prices stipulated in XXX's contracts, establishing assets it acquired and liabilities in the claims of others upon its properly. This self evaluation of the company's equity is called its book value.
Savvy accountants exercise more sophisticated methods, amending their calculations for real world impacts, such as depreciation. Equipment, employed for decades, evaluated at book value as the price at which it was originally bought would be a grievous misrepresentation. This would be easily revealed if they attempted selling that equipment in today's equipment market.
This still, however, only addresses book value. The market's valuing of any company's equity is in no way beholding to its book value. Correspondence between the two can never be expected to either align or diverge. Though, experience shows that divergence is more likely.
Distinguishing between book and market value - not to mention recognizing its relevance to potential investors - profits from clarification of what market capitalization is and how it is determined. All price, naturally, emerge from markets by way of the interplay of subjective values. Every individual's unique, personalized preferences, mixes together to brew the stew of prevailing demand, which determines the relative scarcity of existing supply.
Once companies issue shares, to raise investment funds, these shares are hereafter exchanged in market transactions as a commodity, like any other. After the shares of a company are first issued, they are bought and sold (not to or from the company, but) among individuals entirely independently of the company in whom the shares constitute ownership stock.
Consider an analogy. Sally sells Sam an apple. Preceding the sale Sally was the sole apple-holder. Subsequently, Sam has become the apple-holder. The information provided tells us nothing about whether Sally purchased the apple directly from an apple farmer or from someone else, likewise independent of the apple farmer - say Sandra. What remains unchanged, whatever was the case, is that, unless there was some specified arrangement (i.e., Sally is acting as the farmers sale's agent), Sally had complete ownership of the apple. When she sells it to Sam, he likewise has complete ownership: he is the sole apple-holder. So neither Sally nor Sam has any debt owing to the apple farmer. The latter has already been compensated and surrendered complete ownership of the apple, whether to Sally, Sandra or some other intermediary along the line.
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.
With all this clarified, it is easy to explain the determination of a company's market capitalization and gain some glimmer of insight into why it is both important and distinctive from book value. It starts with a simple calculation. We have seen that a company's shares have a price. All that is required to establish market capitalization is to take the total number of shares issued by the company and multiply that number by the going price for those shares. That rather simple calculation, though, is just the beginning of what is interesting and important.
So, for instance, if XXX had issued one million shares and the market was valuing those shares at $6 each, then the market capitalization of XXX would be $6 million. As it happens, you may recall, that was also the book value of the company determined by its 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.
I've demonstrated elsewhere that under the conditions of fiat currency, money-based saving cannot be treated as a reliable store of your wealth . So, whatever the reasons behind your choice, choosing to invest is a wise decision.
Starting down the investor's path, a valuable bit of knowledge is how you can leverage market capitalization in your decisions. Previously (see the link at the bottom of this article) I have discussed its relevance and usefulness for informing investment decision making. Before those insights can be utilized, though, our terms have to be defined.
Just as it sounds, market capitalization invokes the total value that the market attributes to a company's capital. This value attribution, as we'll see, derives from the pricing of the company's shares. More precisely, the idea of market capitalization captures the market's valuation of a company's equity.
Equity is derived from adding together the total value of the assets (things owned by the company) and the subtracting from that number the total value of the liabilities (things owed by the company). A resulting positive number is the equity.
For instance, a hypothetical company, call it XXX, has total assets (e.g., real estate, equipment, patents) of $10 million. Its total liabilities (e.g. bank debts, settlement in a court case, pending regulatory compliance costs) add up to $4 million. The equity of XXX is calculated by subtracting the $4 million liabilities from the $10 million assets. The equity of the company is thereby established as $6 million.
Before going any further, however, an important qualification needs to be addressed. In our example of company XXX, the value of assets and liabilities, which were calculated to determine equity, was the valuation by XXX of its own equity. XXX's accountants did the calculations. Their beginning point was likely the prices stipulated in XXX's contracts, establishing assets it acquired and liabilities in the claims of others upon its properly. This self evaluation of the company's equity is called its book value.
Savvy accountants exercise more sophisticated methods, amending their calculations for real world impacts, such as depreciation. Equipment, employed for decades, evaluated at book value as the price at which it was originally bought would be a grievous misrepresentation. This would be easily revealed if they attempted selling that equipment in today's equipment market.
This still, however, only addresses book value. The market's valuing of any company's equity is in no way beholding to its book value. Correspondence between the two can never be expected to either align or diverge. Though, experience shows that divergence is more likely.
Distinguishing between book and market value - not to mention recognizing its relevance to potential investors - profits from clarification of what market capitalization is and how it is determined. All price, naturally, emerge from markets by way of the interplay of subjective values. Every individual's unique, personalized preferences, mixes together to brew the stew of prevailing demand, which determines the relative scarcity of existing supply.
Once companies issue shares, to raise investment funds, these shares are hereafter exchanged in market transactions as a commodity, like any other. After the shares of a company are first issued, they are bought and sold (not to or from the company, but) among individuals entirely independently of the company in whom the shares constitute ownership stock.
Consider an analogy. Sally sells Sam an apple. Preceding the sale Sally was the sole apple-holder. Subsequently, Sam has become the apple-holder. The information provided tells us nothing about whether Sally purchased the apple directly from an apple farmer or from someone else, likewise independent of the apple farmer - say Sandra. What remains unchanged, whatever was the case, is that, unless there was some specified arrangement (i.e., Sally is acting as the farmers sale's agent), Sally had complete ownership of the apple. When she sells it to Sam, he likewise has complete ownership: he is the sole apple-holder. So neither Sally nor Sam has any debt owing to the apple farmer. The latter has already been compensated and surrendered complete ownership of the apple, whether to Sally, Sandra or some other intermediary along the line.
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.
With all this clarified, it is easy to explain the determination of a company's market capitalization and gain some glimmer of insight into why it is both important and distinctive from book value. It starts with a simple calculation. We have seen that a company's shares have a price. All that is required to establish market capitalization is to take the total number of shares issued by the company and multiply that number by the going price for those shares. That rather simple calculation, though, is just the beginning of what is interesting and important.
So, for instance, if XXX had issued one million shares and the market was valuing those shares at $6 each, then the market capitalization of XXX would be $6 million. As it happens, you may recall, that was also the book value of the company determined by its 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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All manner of investors have to keep tabs on the newest insights into market cap. To be sure you're fully up to speed be sure to check us out at the Market Capitalization blog.
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