Parker T

Why Market Capitalization Is The True Measure Of A Companys Value



Posted: Sunday, October 12, 2008

by Parker T
Parker

Why is a stock that costs N50 considered cheaper than another stock priced at N10? This question opens a point that often confuses beginner investors: the per-share price of a stock is thought to covey some sense of value relative to other stocks. Nothing could be farther from the truth. In fact except for its use in some calculations, the per-share price is virtually meaningless to investors doing fundamental analysis. If you follow the technical analysis route to stock selection, it's a different story, but for now let's stick with fundamental analysis.

The reason we aren't concerned with per-share price is that it is always changing and, since each company has a different number of outstanding shares, it doesn't give us a clue to the value of the company. Gone are those days when Nigerian Breweries in the brewery subsector was the most capitalized company listed on the floor of the Nigeria Stock Exchange. In the market now the banks are in a tussle over which of them will emerge the most capitalized bank because of the measure of their value.

For that number, we need the market capitalization or market cap number. Find below current StockPicks' 40 most capitalized stocks.

The market capitalization is calculated by multiplying the per share price by the total number of outstanding shares. This number gives you the total value of the company or stated another way, what it would cost to buy the whole company on the open market.

Here's an example.

Stock price = N50

Outstanding shares: 50 million units

Market Cap:N50 x 50,000,000 = 2.5billion.

To prove my opening statement, look at this second example:

Stock price : N10

Outstanding shares: 300 million units

Market Cap: N10 x 300,000,000 = N3billion

This is how you should look at these two companies for evaluation purposes. Their per share prices tell you nothing by themselves.

What does market capitalization tell you? First, it gives you a starting place for evaluation. When reviewing a stock, it should always be in a context like .. how does the company compare to others of similar size in the same industry? The market generally classifies stocks into three categories:

Small cap under N1billion units

Mid cap N1- N10 billion units

Large cap N10 billion units Plus

Some analysts use different numbers and others add micro caps and meg caps, however, the important point is to understand the value of comparing companies of similar size during your evaluation.

You will also use market cap in your screens when looking for a certain size company to balance your portfolio.

As I conclude this week, don't get hung up on the per-share price of a stock when making your evaluation. It really doesn't tell you much. Focus instead on the market cap to get the picture of a company's value in the market place.

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