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.
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.
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.
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.
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.
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.
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 distinguish between book and market value, let's begin with a brief statement of what market capitalization is and how it is determined. Prices of course emerge from markets as a function of subjective value. The totality of everyone's unique, personal preferences establishes the level of demand in relation to the 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.
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.
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.
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.
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.
Alas, lovely and symmetric as that example may be, in real life it rarely works out that way. Understanding, though, why it doesn't and why and how the almost certain discrepancy between book and market value is important for prospective investors requires a more elaborate discussion of market capitalization.
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.
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.
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.
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.
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.
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 distinguish between book and market value, let's begin with a brief statement of what market capitalization is and how it is determined. Prices of course emerge from markets as a function of subjective value. The totality of everyone's unique, personal preferences establishes the level of demand in relation to the 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.
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.
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.
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.
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.
Alas, lovely and symmetric as that example may be, in real life it rarely works out that way. Understanding, though, why it doesn't and why and how the almost certain discrepancy between book and market value is important for prospective investors requires a more elaborate discussion of market capitalization.
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