Market capitalization and total assets are two important figures you should look at when deciding whether a particular stock would make a good addition to your portfolio. While the formula for both of these numbers is very simple, their true values can be surprisingly difficult to arrive at. Therefore, it is crucial to understand how the official figures might differ from the real underlying values.
Defining Market Capitalization
Market capitalization is a measure of a company's total value. This figure is critical as it represents what the market thinks the company as a whole is worth. Companies whose market capitalization lags behind those of similar sized competitors have failed to perform equally well and might not be worth your hard-earned savings.
Market capitalization equals the number of outstanding shares, multiplied by the share price. In theory, this is the amount of money you would need if you were to buy all outstanding shares and fully own the company. In reality, calculating how much a company is worth isn't always this simple. If the company is privately held and the stock does not trade publicly, you must estimate the share price, which can be a challenge.
Understanding Total Assets
Total assets show you how big a player the company is in the marketplace. Especially during economic downturns, these asset-rich companies tend to walk away with the least damage as they often dominate their respective markets.
Total assets are listed on the balance sheet; however, the figure on the balance sheet can be misleading. Most assets are valued at acquisition cost minus accumulated depreciation – in other words, the purchase price minus the value lost as a result of wear and tear. However, some assets lose more value and are worth less than this theoretical book value, while others can be worth far more.
A custom-made crane bought for a million dollars a year ago might be worth less than half of the $800,000 of its book value because it is such specialized equipment that nobody could use it. An office building in a booming neighborhood, on the other hand, might have doubled in value since its acquisition.
Looking at Asset Rich Firms
Generally, companies that have a lot of assets also have a high market capitalization. However, you must study both figures before you invest, because under certain circumstances they can diverge significantly. If the market capitalization of a company is relatively low despite a substantial market capitalization, you may be looking at a corporation with very high debt.
A real estate management company, for instance, might have a dozen office buildings on its books, worth more than a billion dollars. However, the total outstanding mortgage debt on these buildings may be nearly as much, and the total net worth of the company might, therefore, be very small in comparison.
Examining Knowledge-Based Firms
On the other end of the spectrum, there are companies that own very little in the way of hard assets but are worth a lot. Do not ignore such companies, as they could be making their shareholders a lot of money year after year.
A consulting company, for example, whose advice is highly valued in professional circles might be paid more than a million dollars for even the most modest project. It might, however, have almost nothing in the way of quantifiable assets on its balance sheet other than office furniture and computers and therefore have a very low total asset value.
The true assets of such companies are the knowledge and expertise they bring to the table, which is not reflected in the balance sheet. In other words, some companies do not need a lot of hard assets to make a great deal of cash.