Market cap, or capitalization, and market valuation are two terms that sound the same but have different meanings and contexts. A company’s market cap measures its exposure in the stock market based on the share price and outstanding shares. A company’s market valuation, on the other hand, consists of various metrics and measurements used by investors to determine the actual value of the company.
The word “market” comes up all the time when you’re watching CNBC or reading the Financial Times. You have market timing, market fundamentals, market demands, and a whole slew of other terms whose meanings differ. Whether you want to invest in a stock for the first time or are a seasoned industry veteran, two of the most important terms to understand are “market cap” and “market valuation.” They both refer to how much a company is worth, right? Not exactly. The difference is better understood in the context of a company’s stock price versus the actual business that the company does.
Market cap defines a company’s valuation based on the total value of its stock. It’s all the available stock the company has on the market, held by investors, financial institutions, and in many cases, the companies themselves. Market valuation, on the other hand, is a much more nuanced term. Many metrics are used to define market value, such as EBITDA or cash-on-cash growth, and we explain some of those methods in more detail below. Also note that at a given time, the market cap is fixed, and a figure can easily be attained, whereas market valuation is not exact. Different people can have different viewpoints based on their methodology.
Market cap 101
Market capitalization, or market cap, references a company’s value in the context of the stock market. In short, it’s the value of all of the outstanding shares that exist on the market. A company’s market cap is easy to calculate and can be done using the formula below:
A company’s market cap can go up and down with the stock price. So in some cases, it isn’t based on the company’s s fundamental value but rather a trend in the stock market. This is important to understand because government policy can affect the stock market significantly. This can cause many stocks to rise with no regard to whether the fundamentals behind those stocks get better or worse. For instance, if the U.S. government injects an unprecedented amount of money through quantitive easing, then billions of dollars of liquidity will go into the stock market. This money has to go somewhere, and one effect can be a lift of the stock price and market cap without a change to the underlying behavior of the company.
Wheat of the World (WOW) market cap
Let’s take an example of a company we have discussed in previous articles called Wheat of the World. Here is a comparison of the WOW market cap in 2012 and 2014.
WOW shares outstanding: $1,000,000
WOW 2012 share price: $10
WOW 2014 share price: $20
Wow market cap in 2012: $10,000,000
Wow market cap in 2014: $20,000,000
Now, did WOW’s fundamentals really increase enough to double the valuation by 2014, or is part of this a result of the quantitative easing carried out after the financial crisis? The answer to this question can only be determined by using a more detailed market valuation. Other factors besides quantitative easing can also affect market caps. Here are some of the items that can affect stock prices and, thus, market capitalization.
- Supply and demand
- Market fluctuations
- Black swan events
- Interest rate policy
What is quantitative easing?
Quantitative Easing (QE) is a monetary policy used by central banks to stimulate the economy. The strategy is to buy a large number of securities to increase the money supply and encourage lending, which lowers interest rates and — if it works as planned — results in economic growth.
The key here is that market cap directly correlates to the stock market. A company’s drop in market cap does not necessarily mean something has gone wrong with the company. It might be a good value but is just in the midst of a bear market or down cycle. To get a good idea of the nuts and bolts of how a company actually operates under the hood, many will look at a company’s market value.
Not sure how to utilize terms like market cap and market value yourselves? Utilize one these investment advisors.
Market value 101
Market value is a term that encompasses much more than the stock price. In fact, the “market value of equity” is the exact same as market capitalization, which represents a subset of market value. Market value metrics are employed to figure out a company’s actual situation on the ground. Are their sales and/or user base growing? How is their debt burden? Can they afford to grow? What are their overheads like?
Investors and financial professionals will use different methodologies to calculate market valuations. Some of these methodologies are as follows:
- Price-to-earnings ratio
- EBITDA vs. enterprise value
- Price-to-sales ratio
- Earnings per share
- Market/book ratio
Wheat of the World market value based on price-to-sales ratio
Price-to-sales (P/S) ratio is a simple way of measuring a company’s value compared to its stock price by dividing the market value per share by the sales per share. Let’s go back to our favorite global wheat conglomerate.
WOW market cap: $20,000,000
WOW outstanding shares: 1,000,000
WOW price per share = $20
Using the P/S ratio, let’s say that WOW is only generating about $4 in sales per share. That would give the P/S ratio as the following:
As a healthy price-to-sales ratio is considered between 1 and 2, this could indicate that the company’s market value is way below its market cap.
Market cap vs. market value vs. book value
We have now established that market cap is the value of a company based on its outstanding shares in the stock market. Market value attempts to measure the value of a company based on its costs, sales, and various other parts of its inner workings. Both of these terms are not to be confused with “book value,” which, although similar in its purpose to value companies, uses a different set of principles altogether. The book value formula works as follows:
The book value of a company, similar to calculations using EBITDA, takes into account a company’s existing assets and liabilities. Book value is, in most cases, lower than both the market cap as well as the market value. In many ways, it’s used in fundamental analysis to accentuate the downsides of debt and liability. Thus it is often lower than both the market cap and the market value calculation.
Market price or market value, which to choose?
Market cap is a pretty simple calculation; you just multiply the available shares by the stock price and come to a conclusion. Therefore, if you are thinking about investing serious capital, it’s best to learn the methodology that financial professionals use when determining market value. If a company’s market value is much higher than its market cap, this could lead a person to utilize an investment thesis of going long on a stock. Likewise, if the market cap is much higher than the market value, this might nudge an investor to an investment thesis in which they bet the stock will fall.
Is market cap a good indicator of valuation?
A company’s market cap is a good indicator of share market price, but it’s not exact. Most investors will long or short the stock around the difference between the company’s market capitalization versus its current market value, based on their own internal metrics. However, there have been times when the current market price for the stock is quite different than what a company valuation would indicate.
Why is market value more important than stock price?
When looking at the operations of publicly traded companies, market value shows a much more in-depth view of the company’s inner workings, rather than just the stock price.
Is a higher market cap better?
It depends. For an investor, it doesn’t matter except for the idea that if a company is big enough, the government might be inclined to bail them out. For the company itself, it makes raising capital easier if it has a higher market cap.
Is market cap the same as equity value?
Market cap is the exact same concept as the market value of equity. Multiply the stock price by the total number of shares.
- Market cap (or capitalization) and market value (or valuation) are two terms that measure a company’s true value. They seem similar but are quite different.
- To calculate market capitalization, multiply the outstanding shares by the stock price.
- Market value attempts to measure the overall value of the company with a variety of metrics, such as P/S and EBITDA.
- Market cap easy to calculate, but market value is more nuanced. Different people might have different methods to calculate market value.
- Market cap and market valuation might lead to different perceptions of a company’s health. The prospective investor should consider this before making decisions.
View Article Sources
- Market Cap Explained – FINRA.org
- EBIT vs. EBITDA: Differences in Calculations – SuperMoney
- EBITDA vs. Revenue: Differences and Calculations – SuperMoney