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Market Capitalisation

Anyone wishing to gamble in the sharemarket must understand the concept of market capitalisation, and having just talked about penny dreadfuls, this is as good a place as any to discuss it.

A share price of under 10c does not necessarily make a company a penny dreadful, and a price of $20 does not make a stock a blue chip. The share price itself is not what is relevant, it is the monetary value that the market is placing on the company that the investor must be aware of. In order to know this, you must know the number of shares on issue.

This is a very simple concept.

Imagine company A has a share price of 5c. It has 500 million shares on issue, washing around in the marketplace. By multiplying the number of shares by the share price we get a figure of $25 million. This is what the market is valuing the company at, or its 'market capitalisation'.

Company B meanwhile, has a share price of $1.50c, thirty times more that of company A. However, it only has 10 million shares on issue. By multiplying that number by the share price we discover that its market capitalisation is only $15 million, actually $10 million less than that of company A.

So don't be fooled into thinking that a relatively high share price necessarily denotes a big company, or that the converse applies. It is often the case, but by no means always. It is worth remembering too, that a company with a higher market capitalisation is not necessarily a better company than one with a lower market cap. It is just currently valued at more by the market. Some of the small but well run companies of today will be the giant corporations of tomorrow and history shows that some of the poorly run behemoths of today will be gone altogether within a decade or two.

It is important to know the market capitalisation of any stock you are considering buying so that you can assess whether you think the company is worth the value being ascribed to it by the market. Even if you are just looking to buy on your broker's recommendation, it pays to know, as brokers can be wrong and you may be shocked to learn the price tag that is being put on the company you are buying into.

During the excesses of the nineties internet boom at one point it was claimed by an unusually skeptical analyst that even if the internet book company Amazon was to sell every book on earth, the profits after tax and overheads would not be enough to justify its market capitalisation!

One very important thing to look for in working out the market capitalisation of a stock you are interested in is unlisted shares (and options that can be converted to shares for a lot less than the prevailing share price.) Unlisted shares are usually equal to normal shares in every way but are privately owned, often by employees or the company itself, and can't be traded on the stock exchange. They do however represent part of the value of the company and must be taken into account in any valuation of the company.

NEXT ... Knowing your place in the food chain

 


 

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