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.
Elsewhere I've explained why it is that our current fiat currency means that money-based saving cannot be treated as a reliable store of your wealth . So, whatever your motivations are, and personal circumstances aside, a decision to invest is wise.
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.
Just as it sounds, market capitalization invokes the total value that the market attributes to a company's capital. This value attribution, as we'll see, derives from the pricing of the company's shares. More precisely, the idea of market capitalization captures the market's valuation of a company's 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.
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.
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.
Savvy accountants exercise more sophisticated methods, amending their calculations for real world impacts, such as depreciation. Equipment, employed for decades, evaluated at book value as the price at which it was originally bought would be a grievous misrepresentation. This would be easily revealed if they attempted selling that equipment in today's equipment market.
All of this, still, though only concerns book value. The market's valuing of that equity remains an entirely separate matter. Any correspondence between the book and market value of a company's equity is not to be expected. Indeed, experience suggests a divergence of those evaluations is the more likely expectation.
Distinguishing between book and market value - not to mention recognizing its relevance to potential investors - profits from clarification of what market capitalization is and how it is determined. All price, naturally, emerge from markets by way of the interplay of subjective values. Every individual's unique, personalized preferences, mixes together to brew the stew of prevailing demand, which determines the relative scarcity of 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.
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.
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.
Such elegant symmetry, alas, is rarely the situation in the real world. This recognition, though, opens up the discussion to a whole other dimension. Why and how the almost certain discrepancy between book and market value of a company's equity comes to be is vital knowledge for aspiring investors. This though leads us to a more elaborate discussion of market capitalization.
Elsewhere I've explained why it is that our current fiat currency means that money-based saving cannot be treated as a reliable store of your wealth . So, whatever your motivations are, and personal circumstances aside, a decision to invest is wise.
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.
Just as it sounds, market capitalization invokes the total value that the market attributes to a company's capital. This value attribution, as we'll see, derives from the pricing of the company's shares. More precisely, the idea of market capitalization captures the market's valuation of a company's 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.
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.
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.
Savvy accountants exercise more sophisticated methods, amending their calculations for real world impacts, such as depreciation. Equipment, employed for decades, evaluated at book value as the price at which it was originally bought would be a grievous misrepresentation. This would be easily revealed if they attempted selling that equipment in today's equipment market.
All of this, still, though only concerns book value. The market's valuing of that equity remains an entirely separate matter. Any correspondence between the book and market value of a company's equity is not to be expected. Indeed, experience suggests a divergence of those evaluations is the more likely expectation.
Distinguishing between book and market value - not to mention recognizing its relevance to potential investors - profits from clarification of what market capitalization is and how it is determined. All price, naturally, emerge from markets by way of the interplay of subjective values. Every individual's unique, personalized preferences, mixes together to brew the stew of prevailing demand, which determines the relative scarcity of 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.
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.
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.
Such elegant symmetry, alas, is rarely the situation in the real world. This recognition, though, opens up the discussion to a whole other dimension. Why and how the almost certain discrepancy between book and market value of a company's equity comes to be is vital knowledge for aspiring investors. This though leads us to a more elaborate discussion of market capitalization.
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