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.
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.
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.
Let's consider an example. If a hypothetical company XXX had total assets (e.g., buildings, machinery, patents) of $10 million and total liabilities (e.g. bank debts, settlement in a court challenge, pending regulatory compliance costs) of $4 million, then the equity of the company - the difference between assets and liabilities - would be $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.
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 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.
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.
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).
The situation is just the same with the selling of a company's shares. The shareholder is the one who has bought the share and when that shareholder sells the share the entire payment is theirs. Nothing is owed the company in whom the share is a piece of ownership. This is no different than in the apples example. However, just as there is much that goes into determining the price of apples, so it is with the market valuation of any company's shares.
This brings us to determination of market capitalization. At one level, this is a simple calculation. A company's shares have a price, at any point in time. Market capitalization is derived by simply adding up the total number of shares issued by the company then multiplying the number of total shares by the going price.
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.
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.
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.
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.
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.
Let's consider an example. If a hypothetical company XXX had total assets (e.g., buildings, machinery, patents) of $10 million and total liabilities (e.g. bank debts, settlement in a court challenge, pending regulatory compliance costs) of $4 million, then the equity of the company - the difference between assets and liabilities - would be $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.
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 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.
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.
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).
The situation is just the same with the selling of a company's shares. The shareholder is the one who has bought the share and when that shareholder sells the share the entire payment is theirs. Nothing is owed the company in whom the share is a piece of ownership. This is no different than in the apples example. However, just as there is much that goes into determining the price of apples, so it is with the market valuation of any company's shares.
This brings us to determination of market capitalization. At one level, this is a simple calculation. A company's shares have a price, at any point in time. Market capitalization is derived by simply adding up the total number of shares issued by the company then multiplying the number of total shares by the going price.
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.
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:
Investors new and old have to keep tabs on the newest insights into market cap. To be sure you're fully up to speed be sure to follow us at the Market Capitalization site.
No comments:
Post a Comment