If i tell you the price of Apple’s (NASDAQ: AAPL) stock is $180, what does that tell you?
If i tell you that Google (NASDAQ: GOOG) has a stock price of $2770, does that mean Google is a more valuable business than Apple?
Not at all. Why? Because of Market Capitalization.
What is a Market Cap?
If you and I walked by a pizzeria, and I asked, “how much does it cost to buy this pizzeria,” what would you say?
You might fumble a number around, say, between $100k to $1 million, depending on the location. If the place is really popular, you might go beyond a million dollars. In essence, that is what the market cap of a public company is.
The market capitalization is the current price of a whole business, based on the price of its shares at any given time.
For example, if John’s Pizza has a share price of $10 and there are 1 million shares outstanding, then the market cap is $10 x 1,000,000 shares, which is $10 million. In essence, if you wanted to buy the business of John’s Pizza, that is the price to go with.
Why? Because you have to buy out every shareholder in the company. That includes the shares of the CEO, the CFO, the COO, the employees who hold stock, and everyone regular Joe Shmoe that holds John’s Pizza shares.
Now that we understand what the market cap is, lets understand what drives a company’s market cap higher, or lower.
What Moves the Market Cap?
There’s a famous expression that states; in the short-term, liquidity drives prices, whereas in the long-term, fundamentals drive liquidity.
Liquidity is what ultimately drives the market cap.
People tend to put their hard-earned money into stocks with well-known brands, simply because they are brands that people know and love. The sum of all that money is what defines the market cap.
Some of the biggest companies in the world, such as Netflix (NASDAQ: NFLX), McDonald’s (NYSE: MCD) and Starbucks (NASDAQ: SBUX) all have market caps in the hundreds of billions. Apple and Microsoft (NASDAQ: MSFT) currently have market caps closer to $3 trillion.
That is why you occasionally see companies such as Tesla (NASDAQ: TSLA) gaining so much over the course of a year. Hedge funds, institutions and retail investors, such as you and I, have pumped nearly a trillion dollars into the company since March of 2020.
So what is the problem with handing over your cash to the high flying AMC (NYSE: AMC) and GameStop (NYSE: GME)? As i mentioned in a previous article, investors tend to make things complicated.
Evaluating the Current Market Cap
Professional investors need to justify the price of a business. It is not enough to say, “everybody is buying this stock! I need to buy it now!”
This is why, investors use “valuations” to justify their purchase.
Warren Buffet became famous for using the discounted cash flow method (DCF) to determine whether buying a business is worth his time.
He would look at stocks, as if they were private businesses, and try to predict the amount of cash that a company would generate over its lifetime. He would then discount that amount appropriately (see DCF discount rate on google), and compare the results to the current market cap. If the value, Buffet found, was above the current market cap, he would buy the business.
In this way, investors have turned the market cap into more of an estimation of the total amount of cash a company will generate over its lifetime, rather than the sheer amount of liquidity that a stock holds.
Unfortunately, this method hasn’t always played out well for value investors.
This is why a company like Tesla, will blow past value investors. Because, again, in the short-term, liquidity drives the price, not fundamentals.
Amazon (NASDAQ: AMZN) has tended to yield a market cap, way beyond what they actually produce in earnings. Its market cap has been a reflection of investor’s confidence in the path of Amazon’s dominance, and its future growth.
Tons of unprofitable businesses have huge market caps today, simply because investors have jumped in, expecting big returns over the future. So then, does the using the DCF method, or any other valuation method, even matter?
Remember, in the long-term, fundamentals drive liquidity.
Companies like JPMorgan Chase (NYSE: JPM) or Visa (NYSE: V) have maintained a large market cap because they are fundamentally great businesses that continue to generate more earnings. Costco (NASDAQ: COST) and Home Depot (NYSE: HD) will, most likely, continue to grow their market cap as the companies continues to grow their earnings.
But there is a twist.
The higher the market cap, the less future returns you can expect to receive from an investment (see my article on P/E), therefore investors tend to pull money from large-cap investments in the short-term to invest in “cheaper” sectors. This adversely affects the market cap.
This is why you see companies lose billions (or hundreds of billions), in a matter of days, as investors turn their interest to other opportunities.
Maybe, news breaks out that an accountant, for a public company, has committed fraud on their financial statements. All of a sudden, the companies market cap drops by $30 billion, as investors flee the controversial investment.
Or take the example of Peloton (NASDAQ: PTON). Once a hot flying stock, its market cap has fallen by roughly $40 billion over the course of a year, as investors have given up in the company’s future growth prospects.
When enough money leaves a stock, the market cap moves with it.
Market caps reflect many things; sentiment, belief, safety, growth and much more.
It is the sole mission for investors, start-ups and public companies to achieve; a high valuation.
The higher the market cap, the more cash a person can receive for selling stock. We all want to buy into a company with a market cap of $2 billion, and watch it flourish into a $450 billion giant. It’s all part of the investing journey.
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