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I was thinking about this, and was wondering if anyone on here who is a financial nerd can comment. Is market cap really a good way to measure the value of a co

I was thinking about this, and was wondering if anyone on here who is a financial nerd can comment. Is market cap really a good way to measure the value of a company? My understanding is that market cap is (spot price * outstanding shares). The problem is that the spot price is representative only of what a single pair of investors believe their shares are worth. It seems like a better valuation would be something like, "How much would you have to spend to buy the company." Which at any given instant in time is much higher than the spot price-share product, and also probably fluctuates much more slowly.

crapshoot101 13y ago
James, which is why when you do an acquisition of a public company, you py a significant premium - because you don't need to consider just the spot investor; rather, you have to consider what those who think its undervalued believe as well. The spot price / market cap is a good way of getting the marginal value, so to speak of the company - in an acquisition, you're paying a premium to convince others to sell even if it is a significant surplus to what the marginal investor believes.
- jcnnghm 13y ago
  Actually, the premium is usually a multiple of the present value added by the combination of the two companies. Imagine two airlines with many different routes, but a bit of overlap. If they merged, some of those redundant routes could be eliminated, which would reduce the costs and probably increase utilization on the remaining routes, they may also be able to sell the redundant planes and terminal slots. This could potentially represent billions of dollars of value above the sum of the values of the two companies separately. Think about how you would divide this premium between the target and the acquirer. It's actually pretty simple, imagine the next best possibility for the target. If there are many acquirers, the target should appropriate most of that value, hence, a high premium. If the next best alternative isn't as good, the acquirer should capture value. It follows logically that the optimal rational bid for a company is slightly more than the value added in their second best alternative (as an aside, this is really close to how IPO pricing works). Companies aren't necessarily rational though, so in competitive acquisitions companies frequently pay more than the actual value added. Empirically, acquirers in single-bidder acquisitions typically see price-appreciation of about 2% in event studies, whereas acquirers in multi-bidder acquisitions typically see price drops of about 1.33% in event studies. This indicates that acquirers in single-bidder acquisitions typically appropriate some of the added value, whereas in multi-bidder acquisitions, the target company captures all of the value added (plus some) by the acquisition. A really interesting example of this was RJR Nabisco in the 80s. The idea was to separate RJ Reynolds, the tobacco company, and Nabisco, the food company. RJR was a cash machine, but they had a huge uncertain liability from tobacco lawsuits that was depressing the value of the entire company; the separated company was worth a lot more than the company was together. It was trading for about $55/share, then KKR structured a LBO to buy it and break it up, and paid $109/share (management initially bid $75/share for a takeover). In that case, there were many bidders, so the vast majority of the value was appropriated by the shareholders (in fact, KKR didn't generate a good return). [1] In general, the market cap is the best indicator of the true value of a company in it's current configuration. That does not mean there is not some other configuration or combination where the company could be worth a lot more. It's worth mentioning that whenever the market price is incorrect, there is an arbitrage opportunity available to move the price to its true value. HFT is basically designed to capture these opportunities almost instantly, which is exactly what you would expect if markets are efficient. 1: I highly recommend the 1993 HBO movie Barbarians at the Gate, about this LBO.
  - crapshoot101 13y ago
    Yes - its an allocation of consumer surplus (to think about it in the TL:DR) - and what you've described is a pretty standard argument in a leveraged buyout (every conglomerate out there has a PE guy just waiting to take it apart). I endorse the story of Barbarians; however, read the book - its better and more detailed. ;) (forgive me my hipster cliche).
tedsanders 13y ago
That's a fair point, but yes, I think market cap is the best way to measure the value of a company. One problem with the "how much would you have to spend to buy the company" is that it gives you a much larger answer than the "how much would you collect if you sold the company," but it's hard to see why one measure should be preferred over the other. It's true that the spot price only measures the valuation at the margin, but the margin is set by the consensus of the market participants (if anyone disagrees with it, they are free to buy or sell until they agree). The price at the margin of trading also reflects expectations of the company without any change in management (which is one reason that trying to buy or sell a whole company can cost much more or less than the spot price).
- jamesaguilar 13y ago
  I guess what makes me so skeptical about this is the magnitude of change in expectations that relatively minor news can bring. I would say that a rational person should not, for example, value Google or Facebook 20% less or more more because of a single quarter's performance. I feel like one of three things must be the case: - A slight miss or hit of earnings expectations in a quarter really can make a rational person change their valuation of a company by 20%. - The market is irrational. - The spot price doesn't accurately represent the market. It's harder for me to believe the first two than the last one.
  - jcnnghm 13y ago
    A slight miss or hit of earnings expectations in a quarter really can make a rational person change their valuation of a company by 20%. Stock prices are generally considered to be the present value of all future cash flows. In other words, growth prospects are priced in. Because of this, missed earnings can seriously effect value because they can dramatically change market beliefs about probable future cash flows and growth potential. Smaller stocks and high P/E ratio stocks (broadly, growth companies) are particularly vulnerable because the present value of future growth is a higher part of the total value. Edit: Forgot to mention, empirical data typically suggests that markets initially under-react to earnings surprises.
nknighthb 13y ago
There's nothing better that can be objectively measured. It's possible that everyone agrees a company's shares trading at $19 are worth ~$19 +/- a few cents, and there would be no holdouts at all if you offered $20. You'll never know until you try to buy them all. You never really know the price of anything until a purchase is agreed to. A vast field of study exists to seek answers to the generalized form of the question you just asked: "What is the value of X?" I don't know anybody who is entirely satisfied with any of the "answers" the field of economics has given us to that question, so I doubt any answer you get here will really satisfy you, either.
- jamesaguilar 13y ago
  Well, perhaps you could integrate over the outstanding order book (maybe even on both the buy and sell side). I'm not saying it could be answered perfectly, but it might hug the truth better than spot market cap.
berberous 13y ago
Yes, you are correct; part of what you are describing is also known as a control premium. Control premiums obviously exist, but they are likely to correlate to the market cap. For example, a buyer may be forced to pay a control premium of, let's say 20%, to get a public company's shareholders to agree to sell. So if the company has a $500 mm market cap, the buyer might end up paying $600 mm. But if the company later tanks and has a market cap of $250mm, a similar 20% premium, or $300mm offer, would likely still result in a sale, unless a majority of the shareholders believed that the shares were currently and unusually severely undervalued. So I doubt that the price to buy the company would fluctuate much more slowly. And since market cap is an objective measurement, it's often easiest to just think of the market cap, and keep in mind that you will have to pay a control premium if you actually wished to acquire the company.
loceng 13y ago
It depends if enough people who are investing in a company understand the business model and potential sustainable revenue streams, etc..

crapshoot101 13y ago

James, which is why when you do an acquisition of a public company, you py a significant premium - because you don't need to consider just the spot investor; rather, you have to consider what those who think its undervalued believe as well. The spot price / market cap is a good way of getting the marginal value, so to speak of the company - in an acquisition, you're paying a premium to convince others to sell even if it is a significant surplus to what the marginal investor believes.

jcnnghm 13y ago
Actually, the premium is usually a multiple of the present value added by the combination of the two companies. Imagine two airlines with many different routes, but a bit of overlap. If they merged, some of those redundant routes could be eliminated, which would reduce the costs and probably increase utilization on the remaining routes, they may also be able to sell the redundant planes and terminal slots. This could potentially represent billions of dollars of value above the sum of the values of the two companies separately. Think about how you would divide this premium between the target and the acquirer. It's actually pretty simple, imagine the next best possibility for the target. If there are many acquirers, the target should appropriate most of that value, hence, a high premium. If the next best alternative isn't as good, the acquirer should capture value. It follows logically that the optimal rational bid for a company is slightly more than the value added in their second best alternative (as an aside, this is really close to how IPO pricing works). Companies aren't necessarily rational though, so in competitive acquisitions companies frequently pay more than the actual value added. Empirically, acquirers in single-bidder acquisitions typically see price-appreciation of about 2% in event studies, whereas acquirers in multi-bidder acquisitions typically see price drops of about 1.33% in event studies. This indicates that acquirers in single-bidder acquisitions typically appropriate some of the added value, whereas in multi-bidder acquisitions, the target company captures all of the value added (plus some) by the acquisition. A really interesting example of this was RJR Nabisco in the 80s. The idea was to separate RJ Reynolds, the tobacco company, and Nabisco, the food company. RJR was a cash machine, but they had a huge uncertain liability from tobacco lawsuits that was depressing the value of the entire company; the separated company was worth a lot more than the company was together. It was trading for about $55/share, then KKR structured a LBO to buy it and break it up, and paid $109/share (management initially bid $75/share for a takeover). In that case, there were many bidders, so the vast majority of the value was appropriated by the shareholders (in fact, KKR didn't generate a good return). [1] In general, the market cap is the best indicator of the true value of a company in it's current configuration. That does not mean there is not some other configuration or combination where the company could be worth a lot more. It's worth mentioning that whenever the market price is incorrect, there is an arbitrage opportunity available to move the price to its true value. HFT is basically designed to capture these opportunities almost instantly, which is exactly what you would expect if markets are efficient. 1: I highly recommend the 1993 HBO movie Barbarians at the Gate, about this LBO.
- crapshoot101 13y ago
  Yes - its an allocation of consumer surplus (to think about it in the TL:DR) - and what you've described is a pretty standard argument in a leveraged buyout (every conglomerate out there has a PE guy just waiting to take it apart). I endorse the story of Barbarians; however, read the book - its better and more detailed. ;) (forgive me my hipster cliche).

tedsanders 13y ago

That's a fair point, but yes, I think market cap is the best way to measure the value of a company. One problem with the "how much would you have to spend to buy the company" is that it gives you a much larger answer than the "how much would you collect if you sold the company," but it's hard to see why one measure should be preferred over the other. It's true that the spot price only measures the valuation at the margin, but the margin is set by the consensus of the market participants (if anyone disagrees with it, they are free to buy or sell until they agree). The price at the margin of trading also reflects expectations of the company without any change in management (which is one reason that trying to buy or sell a whole company can cost much more or less than the spot price).

jamesaguilar 13y ago
I guess what makes me so skeptical about this is the magnitude of change in expectations that relatively minor news can bring. I would say that a rational person should not, for example, value Google or Facebook 20% less or more more because of a single quarter's performance. I feel like one of three things must be the case: - A slight miss or hit of earnings expectations in a quarter really can make a rational person change their valuation of a company by 20%. - The market is irrational. - The spot price doesn't accurately represent the market. It's harder for me to believe the first two than the last one.
- jcnnghm 13y ago
  A slight miss or hit of earnings expectations in a quarter really can make a rational person change their valuation of a company by 20%. Stock prices are generally considered to be the present value of all future cash flows. In other words, growth prospects are priced in. Because of this, missed earnings can seriously effect value because they can dramatically change market beliefs about probable future cash flows and growth potential. Smaller stocks and high P/E ratio stocks (broadly, growth companies) are particularly vulnerable because the present value of future growth is a higher part of the total value. Edit: Forgot to mention, empirical data typically suggests that markets initially under-react to earnings surprises.

nknighthb 13y ago

There's nothing better that can be objectively measured. It's possible that everyone agrees a company's shares trading at $19 are worth ~$19 +/- a few cents, and there would be no holdouts at all if you offered $20. You'll never know until you try to buy them all. You never really know the price of anything until a purchase is agreed to. A vast field of study exists to seek answers to the generalized form of the question you just asked: "What is the value of X?" I don't know anybody who is entirely satisfied with any of the "answers" the field of economics has given us to that question, so I doubt any answer you get here will really satisfy you, either.

jamesaguilar 13y ago
Well, perhaps you could integrate over the outstanding order book (maybe even on both the buy and sell side). I'm not saying it could be answered perfectly, but it might hug the truth better than spot market cap.

berberous 13y ago

Yes, you are correct; part of what you are describing is also known as a control premium. Control premiums obviously exist, but they are likely to correlate to the market cap. For example, a buyer may be forced to pay a control premium of, let's say 20%, to get a public company's shareholders to agree to sell. So if the company has a $500 mm market cap, the buyer might end up paying $600 mm. But if the company later tanks and has a market cap of $250mm, a similar 20% premium, or $300mm offer, would likely still result in a sale, unless a majority of the shareholders believed that the shares were currently and unusually severely undervalued. So I doubt that the price to buy the company would fluctuate much more slowly. And since market cap is an objective measurement, it's often easiest to just think of the market cap, and keep in mind that you will have to pay a control premium if you actually wished to acquire the company.

loceng 13y ago

It depends if enough people who are investing in a company understand the business model and potential sustainable revenue streams, etc..