Be you a work force newbie, excited about a big raise or your first salary, or a long time breadwinner finally cognizant of the fact that your money either has to work for you or dissipate, investing probably is as new as it is 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.
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.
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.
An illustration: Begin with a hypothetical company, we'll call it XXX. Its total assets (e.g., real estate, equipment, patents) add up to a total of $10 million. On the other side of the ledger, XXX's total liabilities (e.g. bank debts, settlement in a legal challenge, pending regulatory compliance costs) add up to a total of $4 million. The equity of XXX is then determined by subtracting the $4 million liabilities from the $10 million assets, revealing equity of $6 million.
Before going any further, however, an important qualification needs to be addressed. In our example of company XXX, the value of assets and liabilities, which were calculated to determine equity, was the valuation by XXX of its own equity. XXX's accountants did the calculations. Their beginning point was likely the prices stipulated in XXX's contracts, establishing assets it acquired and liabilities in the claims of others upon its properly. This self evaluation of the company's equity is called its 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.
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.
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.
Perhaps a simple analogy could help us, here. Imagine Tony selling an apple to Tom. Before this sale, Tony was the apple-holder. Subsequently, Tom became the apple-holder. With only this information, we don't know if Tony bought the apple directly from an apple farmer or from someone else, equally independent from the farmer - say Todd. In either case, though, in such situations (unless there is a special arrangement, such as Tony being an agent of the farmer) Tony has complete ownership of the apple and sells that complete ownership to Tom. Neither Tony nor Tom owes anything to the farmer who has already been paid for complete ownership of the apple by Tony or Todd, or someone else along the line.
A company's shares are no different. The shareholder exclusively holds the share(s) as a function of a purchase from someone else who likewise had complete ownership. Nothing from the exchange is owed the company and the company has no immediate control over the selling or buying price. This is no different than in the apples example. Determining the price of an apple, though, is a complicated process taking much into account: people's subjective preferences will vary depending on many factors. This too is no different in arriving at the market valuation of a 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.
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.
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.
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.
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.
An illustration: Begin with a hypothetical company, we'll call it XXX. Its total assets (e.g., real estate, equipment, patents) add up to a total of $10 million. On the other side of the ledger, XXX's total liabilities (e.g. bank debts, settlement in a legal challenge, pending regulatory compliance costs) add up to a total of $4 million. The equity of XXX is then determined by subtracting the $4 million liabilities from the $10 million assets, revealing equity of $6 million.
Before going any further, however, an important qualification needs to be addressed. In our example of company XXX, the value of assets and liabilities, which were calculated to determine equity, was the valuation by XXX of its own equity. XXX's accountants did the calculations. Their beginning point was likely the prices stipulated in XXX's contracts, establishing assets it acquired and liabilities in the claims of others upon its properly. This self evaluation of the company's equity is called its 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.
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.
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.
Perhaps a simple analogy could help us, here. Imagine Tony selling an apple to Tom. Before this sale, Tony was the apple-holder. Subsequently, Tom became the apple-holder. With only this information, we don't know if Tony bought the apple directly from an apple farmer or from someone else, equally independent from the farmer - say Todd. In either case, though, in such situations (unless there is a special arrangement, such as Tony being an agent of the farmer) Tony has complete ownership of the apple and sells that complete ownership to Tom. Neither Tony nor Tom owes anything to the farmer who has already been paid for complete ownership of the apple by Tony or Todd, or someone else along the line.
A company's shares are no different. The shareholder exclusively holds the share(s) as a function of a purchase from someone else who likewise had complete ownership. Nothing from the exchange is owed the company and the company has no immediate control over the selling or buying price. This is no different than in the apples example. Determining the price of an apple, though, is a complicated process taking much into account: people's subjective preferences will vary depending on many factors. This too is no different in arriving at the market valuation of a 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.
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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