Common equity and market capitalization are measures of the value of a company. Investors use both metrics when evaluating companies as possible investments. However, common equity and market capitalization measure a company’s worth in different ways. Understanding and using both methods is helpful because it provides a more comprehensive picture of a firm’s prospects.
Common equity is the amount of money shareholders have invested in a company. However, common equity is not always equal to the total shareholders’ equity. If you look at a company’s balance sheet under stockholders’ equity, you will see several categories listed. Some items, such as preferred stock, are not included in common equity. You won’t see common equity listed on some balance sheets. That’s because it is a composite figure that includes several types of shareholder’s equity.
To calculate the common equity of a firm, you add three items together. The first is the par value of the shares. The second is additional paid-in capital. When shares of stock are originally issued, they may sell for more than the par value. Additional paid-in capital is the difference between par value and the actual price investors paid when the shares were issued. Finally, common equity includes retained earnings. Retained earnings are the cumulative profits the company has made over the years but has not distributed as dividends. Once you’ve calculated common equity, you can divide by the number of outstanding shares to find the book value of a single share.
To understand the difference between common equity and market capitalization, you first need to know how market price differs from book value. Common equity and book value per share tell you the worth of common stock on paper. Investors take additional factors into account when deciding how much they are willing to pay for a stock. Suppose a company is losing money or revenues are down. Investors may not be interested unless the market price is lower than the book value. On the other hand, if the company is growing and seems likely to become more profitable, investors may pay twice the book value or even more.
The market capitalization, or market cap, is the market price of a share of stock multiplied by the number of outstanding shares. Suppose a company has a common equity of $40 million and there are 4 million shares outstanding. That gives you a book value of $10 per share. However, the company’s earnings and growth prospects are good and investors are paying $15 per share. The market cap is $15 multiplied by 4 million shares, or $60 million. When you are looking for possible investments, making a comparison like this helps you determine if a stock is a good risk. If you look at a firm’s profits, revenue growth and other factors together with common equity and decide the company’s prospects justify its market cap, you may invest in the stock. If, after evaluating the company, you decide the market cap is excessive, that means the market price of the shares is too high, and you may decide to look for more promising places to invest your money.