Friday, February 19, 2010

Market Capitalization

I noticed that a company like Google (ticker: GOOG) is very expensive at $540 per share and a very well-known and large company such as Microsoft (ticker: MSFT) is trading at only $29. Does this mean that Google’s shares are expensive? Should I consider Microsoft’s shares to be a bargain?

When starting to trade the first thing that you will notice is that even if you have somewhat of a rough idea of what a company does and how successful it is their stock prices don’t necessarily reflect this at first glance. Even if you have two companies that you know are somewhat in the same ballpark in terms of size and success their stock prices can be completely different and this can be disconcerting, however there is a very simple explanation for this.

When you buy stock of a company what you are really buying is a share in the ownership of a company. If you are not used to thinking of yourself as being the owner of a company that you haven’t even set foot in once, you are going to have to start getting used to it. Public companies have many owners and the proportion of ownership is determined by the size of the stake that you have in it. If you have half the shares of a company then you own half the company. If you own 10% of all shares then you are owner of a 10% of the company.

Having even one share of stock in a company means that you are in part owner of the company you have stock in. How large a portion of the company do you own with each share?

In order to know this, all you need to know is the total number of shares that exist for that company. This is called the total number of Shares Outstanding for a certain company. It follows that if you have one share in a company with a total of 100 shares outstanding then you own 1% of the company and so on.

Public companies traded in stock markets in the US and around the world don’t all have the same number of shares outstanding and this is what makes the actual share price of a company a somewhat misleading number without knowing the number of shares outstanding. If you have 100 shares in a certain company what do you have? Is it a large stake? Is it a minuscule proportion of all shares in existence? You would need to know the total number of shares outstanding to determine how large or small your stake in a company’s ownership is.

Because of this, comparing stock prices directly even across companies in the same country, sector, etc. is meaningless. You could however know the total monetary value of all the shares that are outstanding by multiplying the number of shares outstanding by the share price. This number would be the total amount of money that (theoretically) you would need to buy up all the shares of the company so that you are the only owner. This number is called the Market Capitalization (or market cap) and as such, it is a number that can now be more easily used to have an estimate of the size of a company or even to compare companies (keep in mind that in order to actually buy out a company you would need to inherit all the assets and liabilities as well, we’ll talk about this later).

In our example, Google is trading at $540 and has a total of 317 Million shares so its total Market Capitalization is around $171 Billion whereas Microsot trading at $29 has a total of 8.77 Billion shares so its total Market Capitalization is around $252 Billion. As you can see, Microsoft trading at $29 is actually bigger than Google trading at $540 and perhaps it should be as Microsfot earned $6.6 Billion during the last quarter whereas Google earned $1.97 B during the same period.

Also, remember that what you trade in the stock market is shares of equity. A corporation is made up of assets, liabilities and equity and the stock market only looks at the equity portion. The liability portion of it is traded in other markets such as the bond market (for long term liabilities) and also the money market (for short term liabilities).

And if you are thinking that all you need is to come up with the money indicated in the market cap to buy out a company you are not entirely correct. If you want to buy out a company you need to buy out all of its equity but will inherit all of its assets (including cash) and all of its liabilities (debt). In Google’s case for example, the total Market Cap is around $171 Billion but if you want to buy it out you would also inherit cash on its balance sheet of around $25 Billion and since it has total liabilities of zero (no debt) the total amount needed to buy out Google would be around $146 Billion (In reality you would need to offer a premium over the current share price to entice all shareholders to sell you their shares but that will be covered in a separate article).

To summarize, Market Capitalization is a good indication of the size of a company and is the result of multiplying the number of Shares Outstanding (all shares that have been issued) by the stock price.