Have you ever been at a social gathering with someone who studied finance in college? You know, the unbearable kind of person who is all too eager to point out how you are always “not leveraging your time effectively,” or better, uses student loans to finance vacations.
Chances are, this same person excitedly tells you that they bought a share of Company XYZ at $35 a share and sold it off at $45 a share in three months. They never mention the fact they only bought one share (why wouldn’t they buy a ton of shares if they were so smart?). They never mention their analysis, or how they decided the price would appreciate. And money down, they never mention the market capitalization (market cap) or enterprise value (EV).
So, how are these things related?
This is the most basic unit of evaluating a stock. Price is what it takes to buy a fractional share of one unit of Company XYZ.
Now, let me give an example of why this is a misguided approach with two companies everyone knows.
|Company||Price Per Share*|
|Ford Motor Company (F)||$11.08|
|General Motors Company (GM)||$36.34|
*All values for price, market cap, and EV are as of 4/1/2018.
Based upon this table, it looks like Ford is clearly a steal compared to GM! It’s 3.5 times cheaper on a per share basis! Unfortunately, most people fall into this trap with investing. The bad news, it is more complicated than that. The good news, it is not much more complicated to understand price of a company.
What is Market Cap?
Market Capitalization is a simple measure which when used provides a more accurate view of what the company is truly trading for on the stock market. Market cap is usually always listed as one of the key figures when looking at basic financial information (sometimes it is called market value).
Market Cap = Price per share x Shares Outstanding
That’s it. To find market cap, all you do is multiply the price per share by shares outstanding. What are the shares outstanding? It’s nothing more than the number of shares in the company.
So now looking again at Ford and GM…
|Company||Price Per Share||Market Cap|
|Ford Motor Company (F)||$11.08||$44.02 Billion|
|General Motors Company (GM)||$36.34||$50.9 Billion|
What does this number mean? It means if you wanted to buy ALL the shares of General Motors right now, you would pay $50.9 billion to acquire 100% of the shares. (This is hypothetical, the math is a little more complicated, as there are fewer shares the price goes up and does not factor in people who refuse to sell or litigation.)
Market Cap is a useful measure to get a quick picture about the relative size of the company. However, to truly acquire a company, investors evaluate a metric called the Enterprise Value. EV is calculated as follows:
EV = Market Cap + Preferred Shares + Debt + Minority Interests – Cash and Cash Equivalents
As of right now, it is not important to understand the nuances of preferred shares or minority interests. The important thing is to know that enterprise value is what you would theoretically pay to buy a company in its entirety, not market cap.
|Company||Price Per Share||Market Cap||Enterprise Value|
|Ford Motor Company (F)||$11.08||$44.02 Billion||$159.41 Billion|
|General Motors Company (GM)||$36.34||$50.9 Billion||$122.49 Billion|
Next time you are with a stock picking savant from business school who is happy to brag about their savvy at buying a company at $35 and selling at $45, be sure to ask them what the market cap or EV were of the company. Chances are they don’t know. This is just the beginning of starting to wrap your head around how to think about markets.