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.
Market Capitalization Meaning
Market cap is also incorrectly known as what the company is really worth. The market cap formula is simply this:
The amount of dollars per share of a company x The total number of shares of that company.
Market capitalization is about the price of a company.
Company Valuation with Market Capitalization
It is very important to understand that price 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?
The Price of a Company is Not Necessarily the 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.
If you want to learn to properly value a company click here to learn the 4Ms to successful investing.
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.
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.