Market Cap = Share Price x Fully Diluted Shares Outstanding
Unlike shareholders’ equity which is based on historical performance, market cap factors in the perceived value of goodwill, brand equity, quality of management, employees, client relationships, macro economics, competition and very importantly, the present value of future cash flows. It is due to these factors that the market value or share price can be significantly higher than the book value or book value per share.
Take Facebook as an example. Its book value is $41.2bn. It’s market cap is $252.9bn which is approx 6 times higher than the book value. What could explain this premium? The market is able to factor in intangible factors such as the perceived value of goodwill, brand equity, quality of management, employees etc along with the present value of future cash flows that Facebook is expected to generate, which are not captured by a book based measure such as shareholders’ equity. That is why it’s market cap is substantially higher than book value.
But this is not always the case. At the height of the credit crisis in the aftermath of the collapse of Lehman Brothers in September 2008, market cap for most banks and financial institutions in the US were substantially lower than their respective book values!
PRICE EARNINGS (PE)
The price earnings or PE multiple is by far the most popular equity value multiple that is used by wall street analysts and commentators alike. There are two ways that the PE multiple can be calculated. In the first method, market cap is divided by net income or earnings. The second method involves a simple division of the share price by the earnings per share or EPS. Whilst the 2 approaches are very similar, they give slightly different results. This is because, fully diluted shares outstanding are used to compute market cap under the first method. The second method uses EPS which is calculated using weighted average shares outstanding.
If company A has a PE of 10 times, what does this indicate? It simply means that for $1 of earnings, an investor is willing to pay 10 times or $10. The PE multiple of a company is compared to other peers in order to determineover or under valuation.
Though PE multiples are very widely used and are extremely popular, they have some limitations as well.
- PE multiples are based on accounting profits which can be easily manipulated. Earnings are impacted by differences in accounting policies related to depreciation.
- Earnings are also impacted by capital structure i.e how a business is funded, which distorts the true picture.
PRICE OVER BOOK
Another popular equity multiple is price over book value, where price is the market cap and book value is shareholders’ equity. If price over book for a company is less than 1, it may be considered to be a good buy as investors are able to own shares at less than liquidation value. Having said that, a price to book of less than 1 can also imply that all is not well at the company. This multiple is widely used for banking and financial institutions. During the financial crisis of 2008, price to book for most banks in the US was less than 1, as the market had lost confidence in the sector and this sentiment was reflected in their share price.