|Course 401: Understanding Value|
|Measuring Market Capitalization|
The first step to figuring out whether a stock is cheap or expensive is measuring the market value of a company. Unfortunately, the stock price you see in the newspaper or on your computer screen doesn't say anything about how much a stock is really worth. A $100 stock is not necessarily more expensive than a $10 stock, and it may be in fact cheaper.
The most common way of measuring a company's value is market capitalization, or market cap for short. (To recap, the market cap of a company is the total market value of all the company's outstanding stock, representing the share price multiplied by the number of shares outstanding.)
Market Cap = (Number of Shares Outstanding) x (Price of Each Share)
Keeping the number of shares constant, a company's market cap will rise and fall with its share price. The market cap also represents the value the market places on the entire company. The companies with the largest market caps are all big, well-known names and by definition are among the most widely held stocks.
It's worth noting that market cap measures only the market value of a company's equity, and you may remember that companies have access to two sources of capital: equity and debt.
To get around this, investors commonly use a variant of market cap called enterprise value, which tries to measure the value of the actual business itself, stripping away purely financial elements. There are many flavors of enterprise value, but the most straightforward way to calculate it is market cap plus long-term debt, minus cash.
Enterprise Value = (Market Cap) + Debt - Cash
Enterprise value measures how much it would cost someone to buy out all the owners of a company, pay off all the company's debts, and take out any cash that is left over. For example, as of Oct. 31, 2012, General Electric's (GE) market cap was $222 billion, and Chevron's (CVX) was $216 billion. GE had about $272.7 billion in long-term debt and $84.5 billion in cash and equivalents, whereas Chevron had only $9.7 billion in long-term debt but $15.9 billion in cash and equivalents. Thus, Chevron's enterprise value was about $209.8 billion, while GE's was $410.2 billion--a significant difference.
Next: The Meaning of Stock Values >>
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