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.
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.
Now, we already have to backtrack a little. When we spoke of the assets and liabilities as having a value, we were referring to the value attributed to those items on the books of the company. Its accountants have added this all together on the basis of prices that have been stipulated in the relevant contracts: either giving XXX ownership or making claims upon its property. This 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.
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.
To know the difference, then, we first have to know what market capitalization is and how it is determined. Markets of course set prices based on subjective value.
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.
Perhaps a simple analogy could help us, here. Imagine Tony selling an apple to Tom. Before this sale, Tony was the apple-holder. Subsequently, Tom became the apple-holder. With only this information, we don't know if Tony bought the apple directly from an apple farmer or from someone else, equally independent from the farmer - say Todd. In either case, though, in such situations (unless there is a special arrangement, such as Tony being an agent of the farmer) Tony has complete ownership of the apple and sells that complete ownership to Tom. Neither Tony nor Tom owes anything to the farmer who has already been paid for complete ownership of the apple by Tony or Todd, or someone else along the line.
It is the same with company shares: they are bought and sold just like the apple. And just as many factors go into determining the price of the apple at any point in time, so too is the case with the shares of a company.
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.
That's a nice symmetric and convenient outcome. However, in the real world, it almost never works out that way. To understand why not and what this means for prospective investors requires a more elaborate discussion of market vs book capitalization and its relevance to investing.
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.
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.
Now, we already have to backtrack a little. When we spoke of the assets and liabilities as having a value, we were referring to the value attributed to those items on the books of the company. Its accountants have added this all together on the basis of prices that have been stipulated in the relevant contracts: either giving XXX ownership or making claims upon its property. This 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.
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.
To know the difference, then, we first have to know what market capitalization is and how it is determined. Markets of course set prices based on subjective value.
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.
Perhaps a simple analogy could help us, here. Imagine Tony selling an apple to Tom. Before this sale, Tony was the apple-holder. Subsequently, Tom became the apple-holder. With only this information, we don't know if Tony bought the apple directly from an apple farmer or from someone else, equally independent from the farmer - say Todd. In either case, though, in such situations (unless there is a special arrangement, such as Tony being an agent of the farmer) Tony has complete ownership of the apple and sells that complete ownership to Tom. Neither Tony nor Tom owes anything to the farmer who has already been paid for complete ownership of the apple by Tony or Todd, or someone else along the line.
It is the same with company shares: they are bought and sold just like the apple. And just as many factors go into determining the price of the apple at any point in time, so too is the case with the shares of a company.
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.
That's a nice symmetric and convenient outcome. However, in the real world, it almost never works out that way. To understand why not and what this means for prospective investors requires a more elaborate discussion of market vs book capitalization and its relevance to investing.
About the Author:
Investors new and old have to keep up to date 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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