Why Market Cap Valuations are Flawed

Disclaimer: This is my opinion, I’m no investment banker.

“In the short term, the stock market is a voting machine; in the long term, it’s a weighing machine.”

Benjamin Graham

Whenever you hear someone say a company is worth whatever amount, they’re usually talking about the market cap.

Market cap (market capitalization), is the total market value of all of a company’s outstanding shares. It is also known to some as what the company is worth, or the value of the business.

In simpler terms, market cap is the amount of money it would require to buy the company outright in a single transaction. From first glance, this does sound like an accurate way to value a company. But there are a few significantly flawed aspects to this metric as a standard for valuing companies:

Market cap is calculated by taking the per share price of a company multiplied by the total number of shares of that company. So essentially, this is the price of a company.

As with the price of many things, and especially expensive things, price is negotiable—not fixed. Prices are usually determined by some sort of calculation that takes into account the assets’ value to the prospective buyer along with other factors. With market cap valuations, the independent variable is the market price of the stock, which let’s face it, is purely determined by hype.

If market cap is the accustomed way we communicate the value of businesses, then that valuation is easily manipulated by its current popularity and short-term volatility caused by current events, or controversial occurrences.

Many CEOs and business leaders have voiced their aversion to public markets. Numerous have encouraged their stakeholders to ignore their company’s short-term stock performance because of the insignificance of short-term stock movement on the long-term stock performance. Stock prices are moved much quicker and easier by minuscule headline news (such as a controversy, or a rumor) than it does to underreported significant changes to the business.

An interesting example is a report from HBR that shows the insignificance of short-term movement on the long-term performance of a stock price:

We examined the short—and long-term share-price performance of 314 companies that named new CEOs from 2004 to 2009. Of the 49% of companies that saw a first-day rise, just over half—55%—also experienced a long-term gain. And of the 49% of companies that saw a first-day drop, about the same proportion—59%—experienced a long-term gain. (For the remaining 2% of companies, share price on the day of the appointment remained flat.)

When the market’s reaction to the CEO news is dramatic, however, a surprising relationship comes into play. Of the 20 companies whose stock popped 5% or more upon the announcement, only 40% sustained a rise over the course of the CEO’s tenure—but of the 14 companies whose stock plunged 5% or more upon the announcement, 79% experienced a long-term gain.

By definition, investing is a calculated long-term financial play, while speculation has a shorter time horizon and is more guesswork. Large daily changes in the market are generally speculative and don’t mean much as we’ve learned from the example above. Zoom out over a months or years time frame and that is a better representation of a business’s performance.

Long-term investors in Amazon stock who believed in the business’ fundamentals made incredible returns. And while some Amazon speculators made money, there were multiple occasions where the stock had large sell-offs—usually as a result of a negative article or report.

From December 1999 to September 2001, Amazon declined 94%. Investors who believed in the company and were committed to the long-term strategy (and ignored the short-term fluctuations) would have been rewarded with a slice of the $1.47 trillion gain of market value increase. Apple, the largest company in the world today, also had large sell-offs before reaching where it is today. Its stock declined 81% from April 1991 to December 1997.

Blackrock manages almost $10 trillion in assets and is roughly equivalent to the entire global hedge fund, private equity, and venture capital industries combined. They’re one of the largest shareholders in almost every major US company. Despite its massive size and diversification, they have a significantly smaller market cap ($128 billion) than Apple (>$2 trillion) despite having larger profit margins and is the largest asset manager on the planet.

In 2019, Tesla CEO Elon Musk sent an email to Tesla employees encouraging them to “ignore stock price” as it soared to new highs in a market rally. “Ultimately, I think Tesla will be worth considerably more than it is today, but there is a constant debate as to whether that means the value should be higher now or later.” Elon is not the only big-business CEO to remind stakeholders to ignore the volatility and short-term whims.

He concluded his email by encouraging his employees to focus on what’s important—the operations of the business, as this will eventually accurately reflect in the stock price. “This is the unfortunate consequence of being a publicly-traded company. So it goes. Heads-down execution is the right thing to focus on now.”

“Valuation oscillates up and down around value”

Dharmesh Shah, co-founder of HubSpot

We’ve all heard of bubbles. Wikipedia’s definition is “a situation in which asset prices appear to be based on implausible or inconsistent views about the future.” So, basically artificial, speculative, makes-no-sense hype.

At the peak of the infamous tulip mania in 1637, some tulips sold for more than 10 times the annual income of a skilled artisan. When the bubble burst, it became practically worthless. This is an extreme example, but these bubbles happen all the time on smaller scales in the stock market. And keep in mind, market cap valuations are correlated to the stock price.

On the sensible side, valuing a company by calculating its price-to-earnings, return-on-equity, Cashflow, etc., gives a more accurate view on the standing of a company by actually considering its intrinsic values. This way, billions of dollars can’t be wiped off of or added to a company’s value in a single day simply because of a tweet or a rumor.

Market cap of a cryptocurrency makes sense because it’s value is derived from within itself. But a company’s value comes from its business which brings in the money. Businesses add a whole new layer of complexity and factors to consider to properly determine the health of its operations.

To me, market cap is more of a hype index, or quite literally a “market price” which represents the general public’s live and current opinions and speculations for the future of the business. Why we use it as the standard for company valuations in news and communication, I’m not sure. But let’s not confuse value for price.