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.
Market capitalization, as the term perhaps implies, refers to the total value which the market assigns the capital of a business, as expressed through the pricing of a company's shares. To be still more concise: market capitalization captures market valuation of a business' equity.
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.
If the accountants are doing their job properly, their assignment of value is amended for the real world. Matters such as depreciation must be taken into account. Valuing equipment, used for decades, at the original purchase price would rather seriously misrepresent its current value: a fact which would be plainly evident should XXX attempt to sell the depreciated good in today's market.
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.
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.
Shares in a company are a commodity sold on the market like any other. Except for the original public offering, when the shares of a company are first issued, they are sold (not to or from the company, but) between individuals not otherwise connected to that company.
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.
Recall our hypothetical company XXX. Let's posit that it has issued one million shares. If for the sake of demonstration we assume the market values those shares at $6 each, the market capitalization of XXX is revealed as $6 million. By fortuitous coincidence, you'll recall, this was the book value of XXX's equity, as calculated 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.
Market capitalization, as the term perhaps implies, refers to the total value which the market assigns the capital of a business, as expressed through the pricing of a company's shares. To be still more concise: market capitalization captures market valuation of a business' equity.
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.
If the accountants are doing their job properly, their assignment of value is amended for the real world. Matters such as depreciation must be taken into account. Valuing equipment, used for decades, at the original purchase price would rather seriously misrepresent its current value: a fact which would be plainly evident should XXX attempt to sell the depreciated good in today's market.
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.
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.
Shares in a company are a commodity sold on the market like any other. Except for the original public offering, when the shares of a company are first issued, they are sold (not to or from the company, but) between individuals not otherwise connected to that company.
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.
Recall our hypothetical company XXX. Let's posit that it has issued one million shares. If for the sake of demonstration we assume the market values those shares at $6 each, the market capitalization of XXX is revealed as $6 million. By fortuitous coincidence, you'll recall, this was the book value of XXX's equity, as calculated 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.
About the Author:
All manner of investors 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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