Whether you're a newbie in the work force, with a big raise or your first big salary, or you're a long time veteran who finally realized that you have to make your money work for you, investing likely feels as new as it does 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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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