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What is Market Capitalization and Why Does It Matter?

 Joel Anderson, Equities.com

July 4, 2016

Breaking Down Market Capitalization

Market capitalization, typically shortened to just “market cap,” is another way of saying the total market value of a company. Basically, if you take the stock’s price per share and then multiply it by the total number of shares (what’s usually called a company’s “float”), you arrive at what it would hypothetically cost to buy all of the shares of the company, or its total value.

So, for example, the most valuable company in the world right now is Apple (AAPL) with a market cap of about $615 billion. With each share costing a little bit less than $110 and 5.54 billion shares outstanding, you get to $615 billion in total value.

This abundantly simple concept, though, plays a very important role in understanding how the stock market really works.

For starters, it’s important to note that this figure can change pretty rapidly. A company can get some bad news and see its value drop quickly. They didn’t actually sell off any assets or start doing less business, but the perception of the company’s value has changed, and that immediately affects the market cap.

Earlier this year, an upswing in positive sentiment about stock in Google’s parent company, Alphabet (GOOG), drove the price up and saw Google briefly pass up Apple in market cap. In the ensuing weeks and months, the trend reversed itself, investors started to feel a little better about Apple and a little worse about Google, and since then, Apple has returned to the top spot. Nothing notable had really changed about either company, it was just how the market perceived them and what people were willing to pay for each share or stock.

It won’t change, though, if a company changes the number of outstanding shares. For a variety of reasons, a company might decide to simply issue more shares or buy back some from the market. A company might feel its per-share price is too high and split the stock, issuing another share for every share that already exists. This will result in individual shares that are worth half as much, but won’t really change the underlying market cap.

Amazon.com Vs. Wal-Mart: Which is Worth More?

It’s also important to note that market cap doesn’t directly measure the value of the company’s assets or how much money the company makes. This is part of what makes it a little strange. It’s really just gauging the market sentiment about a company. There are other ways of judging a company’s “size,” like measuring its revenue and profit streams against its share price or by adding up what the total value is of all the stuff it holds on its balance sheet (something called “book” or accounting value).

These are typically much more concrete, relying on measurable numbers that don’t tend to fluctuate the way share price can and does. Typically, a market cap that differs greatly from one of those figures is a sign that there’s something making investors feel more positive than the underlying fundamentals would indicate. That can be anything from a guess at some piece of positive news on the horizon to a belief that the balance sheet isn’t really reflecting a bigger underlying reality.

One of the best examples may come from retail. Wal-Mart (WMT) has been the most successful retail store in the world for decades. Amazon (AMZN), meanwhile, is the rising star of the online retail world. When you compare their market caps, Amazon is worth a lot more than Wal-Mart, with a market cap just below $275 billion to Wal-Mart’s about $215 billion (again, it varies slightly based on the day’s market action).

However, if you look at the underlying assets, it paints a very different picture. Wal-Mart has a book value of just over $35 billion, a reflection of its ownership of thousands of stores and distribution centers, a fleet of trucks, and massive amounts of inventory. Amazon, meanwhile, has a book value of just under $11 billion, less than a third of Wal-Mart. In addition, Wal-Mart had a net income in 2016 of $14.694 billion on revenue of $482.13 billion, while Amazon had $35.75 billion in revenue and just $482 million in net income.

So why is Amazon worth a good $60 billion more? On paper, this is an open and shut case: Wal-Mart is the more valuable company by a mile based on its assets and its income. But Amazon the wave of the future, of course. Wal-Mart’s growth is stagnant at this point, while Amazon just keep growing and growing. What’s more, that growth reflects something investors understand about the future: online retail is slowly eclipsing its brick-and-mortar counterpart. As such, investors are willing to pay a lot more for Amazon’s stock than Wal-Mart’s despite the fact that Wal-Mart owns a lot more stuff and makes a lot more money.

The Abstraction of a Company’s Worth

Are the investors right? Is Amazon really on the rise so quickly that you’re better off spending your money on its stock than Wal-Mart’s? Or is this a bird-in-the-hand situation where Amazon investors are foolishly paying for future earnings that may never quite materialize? Maybe both? Maybe neither?

This question is pretty much at the core of buying and selling stock. What is a company really “worth?” How does that value relate to what it owns or how much money it does or doesn’t make? The reality is that no one really knows for sure. Wall Street employs armies of analysts and accountants trying to answer this particular question for any given company at any given point in time, and even the experts are frequently way off.

However, understanding this basic dynamic is pretty important. Once you start to gather this, you can start to understand how companies with different size market caps tend to react differently to different market pressures, or how the methods for comparing market caps can vary depending on which sector a company is in. It’s even essential to understanding the difference between the Dow Jones Industrial Average (DJIA), which weights performance based on share price, and the S&P 500, which is more popular among those working in the financial industry because it weights performance based on market cap.

So the next time you read about a company’s stock experiencing a big shift, take the time to look up its market cap before and after, or maybe compare it to other companies in a similar field. It’s a great way to begin to understand why market cap is such an important concept.

 

Written by Joel Anderson from Equities.com

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