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.
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.
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.
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.
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.
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.
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.
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.
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).
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.
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.
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.
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.
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.
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.
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.
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.
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.
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).
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.
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.
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 newest insights into market cap. To know the score be sure to check us out at the Market Capitalization site.
No comments:
Post a Comment