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.
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.
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.
For those unfamiliar with the term, equity is determined by a relatively simple mathematical operation. The total value of the company's assets (those things it owns) is added together. Then from this total value of assets is subtracted the total value of all the company's liabilities (things it owes to others). 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.
Now, we already have to backtrack a little. When we spoke of the assets and liabilities as having a value, we were referring to the value attributed to those items on the books of the company. Its accountants have added this all together on the basis of prices that have been stipulated in the relevant contracts: either giving XXX ownership or making claims upon its property. This 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 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.
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.
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.
It is the same with company shares: they are bought and sold just like the apple. And just as many factors go into determining the price of the apple at any point in time, so too is the case with the shares of a company.
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.
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.
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.
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.
For those unfamiliar with the term, equity is determined by a relatively simple mathematical operation. The total value of the company's assets (those things it owns) is added together. Then from this total value of assets is subtracted the total value of all the company's liabilities (things it owes to others). 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.
Now, we already have to backtrack a little. When we spoke of the assets and liabilities as having a value, we were referring to the value attributed to those items on the books of the company. Its accountants have added this all together on the basis of prices that have been stipulated in the relevant contracts: either giving XXX ownership or making claims upon its property. This 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 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.
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.
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.
It is the same with company shares: they are bought and sold just like the apple. And just as many factors go into determining the price of the apple at any point in time, so too is the case with the shares of a company.
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.
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.
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