What is market value?

Introduction to market value

An asset's market value is the amount of money a seller expects to receive from a buyer. The asset could be anything from artwork to real estate to financial instruments like stocks, bonds, or derivative contracts.

In the case of share trading, market value typically refers to a stock's market capitalisation or the total value of all outstanding shares in the company.

We calculate market cap by multiplying a company's current stock price by its total number of outstanding shares. Market cap is a relatively intuitive financial metric. If you wanted to acquire an entire company, you would first need to buy all of its shares from the current owners (the company's shareholders). 

Therefore, market cap is roughly equivalent to a public company's total market value. 

Of course, as we will see, market cap does have some limitations. Some analysts use other financial metrics to evaluate a company's total value. Enterprise value factors in a company's debt, for example.

Calculating market value for some assets can also be complex and subjective. While data on a company's stock price is widely available and updated frequently, information can be more difficult to come by for other assets like property and artwork. Estimating the market value of these assets requires the work of professional appraisers and analysts, and even they can often get it wrong. 

The entire share market can also have a value – the sum of the market caps of all the trading companies. We can compare the share market value with other financial markets like bonds, derivatives, and commodities. The value of different financial markets can fluctuate in response to macroeconomic factors such as inflation, interest rates, and tax rates.

Why is market value important to investors?

Market value is significant because it provides clear indications about how the investment community views the business prospects of different companies. This helps you determine which companies might be suitable investments, especially if you are just starting out on your investing journey.

For example, investors often categorise stocks according to their market caps. The main categories are large-caps, medium-caps, and small-cap shares. Companies with the largest market caps are usually blue chips with a long history of success. They are typically low-risk and may pay regular dividends.  

On the other hand, small and micro-cap shares tend to be much more speculative investments. Some might be junior companies that are yet to prove themselves,  but they may have the potential to grow into tomorrow's blue chips. However, because they are usually an unknown quantity, small-caps are also inherently riskier, and so some investors may choose to avoid them entirely.

Market value is also important because we can use it as an input into other financial ratios and models. This can help market analysts – including you – identify instances when the market might be undervaluing a particular stock. These moments present ideal buying opportunities. 

Remember: A company's market value does not always reflect its intrinsic value. For example, you might see great potential in a company that everyone else seems to think is a lemon. If you're right and the company becomes successful, you might soon find yourself sitting on a handsome gain. Of course, if you are wrong, you could lose a lot of your money – and your friends will never let you live it down.

How to calculate the market value of a company

As discussed, we can easily calculate the market value of any publicly traded company using this simple formula:

Market value = current share price x number of shares outstanding

Information about Australian stocks is readily available on the ASX website¹ or other financial websites, including the Motley Fool Australia². Just search for a company's ticker on our homepage. 

Once you have the information you need on a specific share, calculating its market value is easy. For example, mining giant BHP Group Ltd (ASX: BHP) is currently the largest company trading on the ASX. 

BHP has 5,065,820,556 shares on issue, with a share price (at the time of writing) of $49.24. Multiplying one by the other gives a total market cap of about $250 billion. This is BHP's current market value.

Small-cap sports technology company Catapult Group International Ltd (ASX: CAT) has 244,057,884 shares currently outstanding, with a share price of just 70 cents. This gives it a total market value of about $172 million.

This big difference in market value tells you a great deal about these two companies. BHP is a global leader with a long history, while Catapult is still trying to establish itself in a tough macroeconomic environment. Depending on your risk appetite and investing goals, this might be enough information for you to decide which of these two companies fits best in your portfolio. 

Using market value to evaluate a company

As we mentioned earlier, markets often get their pricing wrong. Opinions about companies differ, and the financial media generally gives more coverage to larger companies. Identifying when markets are most wrong with their pricing of shares or indices is the central goal of value investing. These are the times when you could profit the most from buying undervalued shares.

Analysts will use a company's market value to determine whether its stock is a buy or a sell. Using financial models, they will calculate their estimation of the company's intrinsic value and compare this against the value the market has placed on the company's shares. If they calculate a higher inherent value than market value, the stock could be trading at a discount and might be a buy. If they calculate a lower intrinsic value, on the other hand, it could be a sell.

Evaluating a company's intrinsic value can be complex and subjective – it keeps financial analysts in a job. However, you don't need a finance degree to understand some of the most common financial metrics used to determine intrinsic value.

Common valuation metrics

Some of the most commonly used valuation metrics are listed below: 

P/E Ratio

A company's price-to-earnings (P/E) ratio is one of the most frequently quoted financial metrics. Many financial websites will publish a share's P/E ratio, but you can also calculate it yourself using the formula below:

P/E ratio = market cap / annual earnings 

Essentially, the P/E ratio tells you how much you have to pay for every $1 of the company's earnings. By comparing a company's P/E ratio with its competitors, or the industry average, you can work out whether it might be undervalued or overvalued relative to its peers.

Yield curve

The yield curve is used to evaluate stock markets as a whole. It is a way to predict the likelihood of a near-term recession, which could cause a market crash or a prolonged bear market.

The yield curve compares the yields on short-term and long-term government bonds. Usually, longer-term bonds have higher yields than shorter-term bonds to compensate investors for the additional interest rate risk that comes with the longer bond duration.   

The yield curve is said to be 'inverted' when short-term yields exceed long-term yields. This implies that short-term risk is greater than long-term risk – a situation that usually indicates a recession is coming. It's a bearish signal for share investors, as business conditions will worsen during a downturn and share prices will usually fall.

Interest rates

Analysts can use interest rates to try and determine whether the overall market is fairly valued. When interest rates are low, businesses can borrow more cheaply and use that money to fund expansions. When interest rates rise, borrowing costs go up, and company profits will tend to shrink.

If interest rates are well above their historical trends, but the share market is still trading at all-time highs, it could signal that it is overvalued. On the other hand, if interest rates are dropping below their long-term trend but the stock market is still trading at lows, it could be due for a recovery.

Margin debt

Investors can use borrowed money to invest in stocks – a practice known as trading on margin. By tracking margin debt levels, analysts can judge whether the market might be overvalued and due for a correction.

Investors tend to borrow more when prices rise as they see an opportunity to magnify their gains. However, this means that when margin debt levels are peaking – and investors are at their most greedy – there is a heightened risk of a market correction. If a sell-off starts, margin traders will have to rapidly repay their debt, which could spark a crash.

ASX 200 mean reversion

This is a fairly simplistic metric. It assumes, over time, that the S&P/ASX 200 Index (ASX: XJO) will return to its long-term average trend line. When it is far enough above this price range (say, by two standard deviations or so), this would be read as a sign that the market is overvalued.

Alternatively, when it is far below this price range, it could signify that the market has been oversold, and prices might soon begin to rise.

What is a 'good' market value?

When market prices are a relatively accurate reflection of the underlying fundamentals of the companies making up the exchange, the market is considered to be 'fairly valued'. This usually means less volatility, thus more stable market conditions to reliably grow your wealth.

When the market is grossly over (or under) valued, it can create more volatility in share prices. While this can present opportunities to buy shares at discount prices, it also makes it more likely that you will suffer a loss. 

What are the limitations to market value?

Although it is a useful financial metric, market value still has many limitations. 

The market value of a company – as measured by its market cap – doesn't account for its debt levels. This is an important consideration because if you acquire a company, you will also take on all its outstanding debt. Other measures, like enterprise value, seek to address this limitation by including a company's outstanding debt alongside its equity to determine its intrinsic value.

Secondly, a company's market cap represents the investment community's consensus view based on publicly available information. Naturally, there is usually more information about larger companies, as they receive more coverage in the financial media and are typically recognisable brands. 

This type of information asymmetry means the market values of smaller, junior companies are less likely to reflect their true intrinsic values. As we've already discussed, this creates opportunities to profit but can also increase your risk of a loss.

Therefore, always take a company's market value with a grain of salt. While it is a handy financial metric, you should always combine it with other analyses before deciding whether you'd like to buy a share.