“Everyone is working to measure a company’s true market value,” Asher Rogovy, Chief Investment Officer at Magnifina, says. “Whoever understands the true value can profit by trading mispriced stocks. Market capitalization represents how investors, on average, estimate true market value. It’s one indicator of market value and a great starting point for analysis.”
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“Indeed, Market Capitalization is standardized and easy to calculate using any public company’s quarterly reports and market price. It represents a kind of “aggregate valuation” by market participants. In other words, market cap is the “market’s” best guess for market value. Market Value, on the other hand, is the “true” value which is unobservable. There may be some estimators of market value (e.g. P/E ratio), but the theoretical “true” value is more likely based on something like DCF. In practice, DCF analysis is far from perfect — who could possibly know cash flows and interest rates 10-50 years into the future?
The Efficient Markets Hypothesis would imply that Market Cap should equal Market Value. However, this breaks down frequently. “Story stocks” which are popular may experience prolonged distortions in how the market values them. Also, short term news can cause distortions. Even volatility in unrelated markets can cause distortion — one theory is that the Covid-19 bear market was exaggerated by portfolio rebalancing. During this period, market caps deviated from many analysts’ best measures of long-term valuation.
Finally, there is no market cap without a public market. So we must use estimates of market value when referring to private companies. To illustrate with an example: the global market for cannabis is estimated at $200B per year. This means that if legal cannabis companies captured 50% of sales, the legal industry would take $100B. Assuming there would eventually be only 5 surviving global cannabis enterprises (and using a 1:1 Price-to-Sales ratio) each would safely be worth $20B in market cap. Of course, now that there are many listed companies, this analysis is less useful. But it’s one way that early investors might have approached long-term valuation.”
Quote altered with permission