Be you a work force newbie, excited about a big raise or your first salary, or a long time breadwinner finally cognizant of the fact that your money either has to work for you or dissipate, investing probably is as new as it is necessary. The latter, by the way, seems to be a growing category.
In a fiat currency world, money-based saving cannot be treated as a reliable store of your wealth . Your motivations and personal circumstances, be what they may, deciding to invest your wealth is wise.
An important tool for all investors, especially those new to the process, is learning how to leverage market capitalization. Elsewhere (see the link at the bottom of this article) I explain its relevance to informed investing. Before though one can discuss that, 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.
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.
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.
Again, though, this all still only reveals the book value. The market's valuation is of course an entirely separate question. This doesn't mean it is necessarily different from the book value, but neither can the two ever be assumed to be the same.
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.
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.
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.
Alas, lovely and symmetric as that example may be, in real life it rarely works out that way. Understanding, though, why it doesn't and why and how the almost certain discrepancy between book and market value is important for prospective investors requires a more elaborate discussion of market capitalization.
In a fiat currency world, money-based saving cannot be treated as a reliable store of your wealth . Your motivations and personal circumstances, be what they may, deciding to invest your wealth is wise.
An important tool for all investors, especially those new to the process, is learning how to leverage market capitalization. Elsewhere (see the link at the bottom of this article) I explain its relevance to informed investing. Before though one can discuss that, 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.
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.
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.
Again, though, this all still only reveals the book value. The market's valuation is of course an entirely separate question. This doesn't mean it is necessarily different from the book value, but neither can the two ever be assumed to be the same.
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.
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.
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.
Alas, lovely and symmetric as that example may be, in real life it rarely works out that way. Understanding, though, why it doesn't and why and how the almost certain discrepancy between book and market value is important for prospective investors requires a more elaborate discussion of market capitalization.
About the Author:
All manner of investors have to keep tabs on the hottest scoop on market cap. To know the score be sure to check us out at the Market Capitalization site.
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