There is a tendency in financial journalism to refer to a company’s market capitalization as what the company is “worth,” or its “value.” This tendency is most pronounced when people describe a private company raising capital, for example describing Uber as “worth” $62.5 billion. These valuations are arrived at by comparing the price paid to the share of the company purchased: if $3.5 billion in cash buys you 5.6% of the company, the company must be “worth” $62.5 billion.
This is absolutely preposterous. Market capitalization doesn’t matter because share prices don’t matter.
Share prices tell you at what price shares recently changed hands
When the stock market closed this afternoon my shares of Mattel were quoted at $25.76. As there are 342,045,279 shares of Mattel outstanding, the company’s market capitalization is about $8.81 billion.
From this, your Bloomberg talking head will conclude that Mattel is worth $8.81 billion. This is false.
You cannot buy Mattel for $8.81 billion
It is true that if you want to buy 100, 1,000, or even 10,000 shares of Mattel, you could probably do so for about $25.76 per share. On average 4 million shares change hands every day, so there are always a lot of people trying to sell their shares (although you still have to compete against all the people trying to buy them as well).
If you try to buy 100,000 shares of Mattel, you’re going to find that there just aren’t that many people willing to sell shares at $25.76 each. The price is going to inch up as you exhaust the shares available at each price point. And as the price inches up, the market capitalization, which is simply the multiple of the number of shares outstanding and the last price a share changed hands at, will also increase.
If the market capitalization were the “value” of the company, this process would be increasing the value of the company. But it obviously isn’t increasing the value of the company: it’s a mechanical process of paying more and more money to people depending on their willingness to part with their shares.
If every single market participant had some price they were theoretically willing to sell their shares at, the final share you purchase, the 342,045,279th share, will be the final price quoted on the market, perhaps at $50, $100, or $1,000, giving your toy company a market capitalization of $342 billion. But “the market” doesn’t “value” Mattel at $342 billion — that calculation is purely an artifact of the last price the stock traded at.
You cannot sell Mattel for $342 billion
The same process would work in reverse if you tried to sell your 342,045,279 shares of Mattel. You might find an eccentric willing to buy the first share for $1,000, but after that you’d quickly find yourself offering your shares for less and less money in order to entice reluctant buyers. The final share you sell might fetch you as little as $25.76, resulting in a market cap of a mere $8.81 billion, despite the fact that you received much more than that as you sold some shares for $1,000, others for $50, and others still for $30.
There are shares that are unavailable at any price
The Vanguard 500 owns 5,070,147 of Mattel, and they aren’t for sale. As you bid up the price of Mattel on the public markets, there is no one at Vanguard authorized to cash in on your lunacy. Since Mattel is in the S&P 500, Vanguard will hold its shares all the way up and all the way down.
You will never buy Mattel on the public markets while Vanguard, Fidelity, Blackrock are sitting on shares that their index funds are legally bound to hold.
What is a company worth?
The point of this exercise is not to say that it’s impossible to value companies, or that there’s no such thing as value, or that market capitalism itself is some kind of hoax. It is only to say that a company’s market capitalization is not the value of that company, because it’s not the price of that company.
It is perfectly reasonable to ask what a company is worth, and it’s perfectly reasonable to express that value in dollars. So here’s my crystal clear answer about what a company is worth:
“Somewhat more than its average price across the entire business cycle.”
That is what a company is worth because that is what it would cost to acquire the company — that’s the price of the entire company, not just 1/342,045,279th of it. When you want to buy a company, you make an offer for all the shares, so that shareholders willing to accept a lower price don’t get stiffed while those willing to wait sell you the last share for $1,000. Everybody gets the same price, and that price is “somewhat more” than the average price of the stock.
It is good that we have deep and liquid capital markets, because they allow people to be practically certain they can buy and sell their shares at some price. But using share prices as a measure of the value of a company confuses the froth for the ocean. Companies can be valued, they can be bought, and they can be sold, but publicly traded share prices on a given day are absolutely irrelevant to those enterprises.