Please describe market capitalization as a valuation method, what are strengths and weaknesses? Then, please discuss book value as a valuation method. Compare it to market capitalization.
A Company’s market capitalization is calculated by multiplying the number of outstanding stocks and the current market price of one share. This one way to calculate the value of the business by investors (Investopedia, n.d.).
For example “Xyz Company” has 10 million outstanding shares and in a major stock exchange, one share is being sold at $50. In that case, the market capitalization of this company is only $500 million and investors might call it a small cap company at current context. Apple, Google, Exxon they are big cap companies, but the formula to calculate market cap is same all across for all companies.
It is a fairly easy way to calculate the value of a company and an investor might decide to invest solely based on the market cap, although that won’t be a good investing strategy. One simple fact is, an investor with $50 million to invest can buy every single share ( but the current shareowners should be willing to sell) and own 100% of the business.
Market capitalization definitely tells us how the market values the company, risk, the future of the business and capabilities of generating cask. But then it is all from market’s perspective, might not necessarily be accurate.
So the weaknesses are, for example during great depression or more recently during financial crisis many great companies share price fell and market capitalization also fell dramatically, but the underlying business model was not impacted due to the fall of the share price. So, greatest weakness is, the market cap is not the greatest tool to measure the strength of the underlying business.
Book Value – is the value of the business based on the balance sheet.
Book value = total assets – total liabilities
In other words, it is the difference between the total assets and total liabilities (Investopedia, n.d.). If we go back to “Xyz company”, say its total asset is (i.e.: current assets+ long-term assets) worth 1 billion and total liabilities (i.e.: current liabilities + long-term liabilities) worth 1 billion to. In that case, the book value of the business will be worth 0 dollars.
Now you can ask, then why the market capitalization is 500 million. The market values the customer base the company has the employee, the knowledge and other intangible assets the company might have, more importantly, the market values the earning potential of the company in future. Hence book value and market capitalization are very different valuation methods.
Now for certain companies such as real estate or banks, book value might be important. Especially for a real estate company that sells properties. We can figure how much property or inventory they have to sell, same goes for banks, we can understand if the bank has more assets to back all the liabilities. But market capitalization would vary based on the earning potential or expectation, and it might not work based on book value all the time. Another instance might be, sometimes the older the company gets the better the book value of the company gets. One example would be unsold inventory, equipment, even the old equipment those are not being used anymore help to boost the book value. But all those assets do not help the company earn more, so the market capitalization might not get much help from a big book value.
Book value can be calculated per share too. book Value per share = Total book value/number of outstanding shares.
Retrieved on 5/12/2018. Retrieved from https://www.investopedia.com/terms/m/marketcapitalization.asp
Retrieved on 5/12/2018. Retrieved from https://www.investopedia.com/articles/investing/110613/market-value-versus-book-value.asp