Thursday, November 27, 2008

Market Cap -- what it means

While reading about the Citigroup bailout I saw a rather dumb statement in some of the news coverage.

Okay, okay, I saw a great many dumb statements, but most of those were of the ordinary "this bailout is a sad but necessary step to ensure the stability... blah blah blah variety." What stood out this time was a blatant misunderstanding of how the stock market, and indeed, free exchange, works from somebody who should know better.

Here's the statement that got my attention:
Given that Citigroup's entire market value on Friday was $20.5 billion, "instead of taking that $20 billion in preferred shares we could have bought the company," he says.
On the surface, that sounds pretty reasonable. After all, Anil Kashyap, the Edward Eagle Brown Professor of Economics and Finance at the University of Chicago's Booth School of Business should know what he's talking about.

There's just one problem.

This statement is only correct given circumstances that basically never exist.

So, here's an explanation of what Market Valuation actually means, so the next time somebody smart says something dumb like this you too can be annoyed. As a side note, I've said things like this myself -- without realizing I was just grossly wrong. Live and learn.

What does Market Value or Market Capitalization mean.

From Wikipedia: "Market capitalization represents the public consensus on the value of a company's equity."

Again, this statement is only sort of correct.

The market cap is the based on the price "negotiated" between the most recent buyer and seller of the stock.

Each stockholder has their own perceived valuation for their shares. Each knows the minimum amount they would sell for. Each potential buyer of a stock also has their own perceived valuation for the shares and each knows the maximum they would pay.

At any given time, many shareholders aren't currently interested in selling their shares because their valuation doesn't match a buyer's. If I held Citigroup stock and felt it was worth $60 a share, I'm not going to sell -- not today anyway.

The market cap of a company is based on the price of the last sale -- independent of the size of that sale. As few as 1share may have changed hands, but that still sets the market cap. The only time the price of the last sale is indicative of the actual cost to buy all of the outstanding shares is when all of the existing shareholders would be willing to sell for that price.

That clearly wasn't the case last Friday when only 1billion of the 5.45 billion outstanding shares changed hands.

The current share price is best information about the perceived value of a company, but it most certainly doesn't reflect the price at which all outstanding shares could be purchased.

Thinking of market cap that way is just sloppy thinking.

1 comment:

Max said...

Keep in mind that to "buy" a company, you only really need to get a controlling stake in it (usually, 50%+1).