One of the most enjoyable things about financial markets is that they provide objective answers for basic investing questions such as "How much is that company worth?" The answer is, "Whatever people will pay for it." The financial term for that is market capitalization, and you can measure it two ways: the regular way or the fully diluted way.
Corporations divvy up their ownership with shares of stock. Buy one share of Amalgamated Wig Corp., and you're a partial owner of the company. If you own, say, 10 percent of the stock, then you own 10 percent of the company. Buy up 100 percent of the shares and you own 100 percent of the company. Since you can buy the whole company for the combined price of all the shares of stock, that price must be the price for the company.
A company's market capitalization is the current market price of all its outstanding shares -- that is, the stock currently in investors' hands. If Amalgamated Wig has 10 million shares outstanding, and the stock is selling for $5 a share, Amalgamated Wig's market cap is $50 million. If you've got $50 million to burn, you could buy yourself a wig company. (Then again, if word gets out that you're on the prowl for 100 percent of Amalgamated Wig shares and will stop at nothing to get them, people are going to buy shares to try to make a profit for themselves, which will drive up the price and the company's market cap.)
The basic market capitalization formula multiplies the company's market price by the number of outstanding shares. But many companies find themselves in a situation where the number of outstanding shares could suddenly rise. One such instance is when employees have stock options, which give them the opportunity to buy stock from the company at a certain price at a certain time. Some companies also issue convertible securities, such as bonds that can be converted to shares of stock.
A company's fully diluted market capitalization is what its market cap would be if all stock options were exercised and all convertible securities were exchanged for stock. Say that in addition to 10 million outstanding shares, Amalgamated Wig Corp. also had options and convertible securities that could dump another 500,000 shares into circulation. At the current market price of $5 a share, that would bring the fully diluted market cap to $52.5 million. That wig company of yours is really getting expensive.
If the number of outstanding shares in a company were to quickly rise by 5 percent, as is the case with the Amalgamated Wig example, that might well push down the price of existing shares (unless there's all sorts of pent-up demand for wig stocks). That suggests the fully diluted market cap might not be a terribly reliable figure for the company's value. At the same time, the current price might already reflect the prospect that 500,000 new shares could soon flood the market, in which case the diluted cap would be accurate. In the final analysis, fully diluted market cap can serve as something of a reality check. It prompts investors to examine how much the company is really worth.
- "The Wall Street Journal Guide to Money and Investing"; Kenneth M. Morris and Virginia B. Morris
- "The Wall Street Journal": For Tech Firms, Beware the Power of Dilution
- Allen Latta: Market Capitalization v. Fully-Diluted Equity Valuation