Rule #1 Finance Blog

With Investor Phil Town

Market Capitalization Meaning: Why Price Doesn’t Always Equal Value

Market cap, also known as market capitalization is the total market value of all of a company’s outstanding shares. It is also incorrectly known to some as what the company is really worth, or in other words the value of the business.

Keep reading to learn more about why it doesn’t always reflect a company’s actual value.



What is Market Cap?

Also commonly referred to as “market capitalization,” this is a term that refers to the total market value of a company’s outstanding shares. To put it another way, it’s the amount of money that it would require to buy the company outright in a single transaction.

Market Capitalization Meaning

Market cap is also incorrectly known as what the company is really worth. The market cap formula is simply this:

The per share price of a company x the total number of shares of that company = Market Capitalization

I want to be very clear about this: Market capitalization is about the price of a company.

Market Cap vs Market Value

While market cap and market value are each a measurement of corporate assets, they’re each taking incredibly different roads to get to what is essentially the same destination. Market cap is a very straightforward calculation, but market value is infinitely more complex. It’s assessed using factors like price-to-earnings, return-on-equity, and others.

Other metrics that are usually considered include outstanding bonds, corporate debt, interest payments, and even long-term growth potential. Market value also has a tendency to fluctuate over time, particularly during bear markets and recessions.

How Does Market Cap Affect Stock Price?

Generally speaking, the investment community uses market cap as a viable way to determine a company’s size. Indeed, the stock price is a core part of the market cap calculation to begin with. Market cap is determined by taking the number of a company’s shares and multiplying that by the current price of one share.

As an example, a company that currently has 10 million shares that were all selling for $50 per share would have a market cap of $500 million dollars.

Why is Market Cap Important?

Analysts will tell you that market cap tells you what a business is really worth or the “true value”. That’s simply not true, because market cap only gives you a piece of the story. It’s very important to understand that the price of a stock is not necessarily the value of a company.

Price is what you pay for something, but VALUE is what you get.

Let’s say you go out and buy a new Maserati, we’ll say that the value of the car is $100,000. If I paid $200,000 dollars for the car, it doesn’t mean that it’s worth $200,000. That’s just what I paid for the car. I massively overpaid for it.

Now, on the other hand, if I paid $50,000 for it, it also doesn’t mean that it’s worth $50,000. That’s just what I paid.

What’s really important to understand about stock investing in the public market is that market cap is just what we pay. What we need to know, this is how it relates to Rule #1 Investing, is what the company is worth. What is the company’s value?

If we see that the company is worth more than the market cap has it priced at, then we know that we’re essentially buying a $10 bill, for $5 bucks.

The market cap is the big mistake that people and investors make in assuming that whatever the market is charging for a company, is what it’s worth.

A lot of people say that market cap is the value of the business. In fact, that is so commonly done that professors at some of the best universities in the country have made this mistake over and over again by assuming that what the market price is of a business is what the business is worth.

Warren Buffett says that, “Nothing is further from the truth.”

When you understand that about market capitalization and value, you’ve just taken your first major step to becoming a really great investor.

If you want to learn to properly value a company click here to learn the 4Ms to successful investing.

Remember that market cap is a reflection of what we would pay today to own a piece of the company. But this price is not the true value of the business. If we make market cap the only metric to determine whether or not we invest, we are letting the market price of the business tell us what the business is worth, instead of using all of the data available to a Rule #1 investor.

I’ve created a free calculator to calculate market cap for you and navigate the tricky issue of price versus value.

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Phil Town is an investment advisor, hedge fund manager, 3x NY Times best-selling author, ex-Grand Canyon river guide and a former Lieutenant in the US Army Special Forces. He and his wife, Melissa, share a passion for horses, polo, and eventing. Phil’s goal is to help you learn how to invest and achieve financial independence. You can follow him on google+, facebook, and twitter.
Summary
Market Capitalization Meaning: Why Price Doesn't Always Equal Value
Article Name
Market Capitalization Meaning: Why Price Doesn't Always Equal Value
Description
The market capitalization price of a company and the company's actual value are two VERY different things. Learn how to properly value companies here.
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Rule One Investing
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