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.
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.
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 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.
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).
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.
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.
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 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.
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).
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.
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 need tokeep up to date on the hottest scoop on 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