PROS AND CONS OF A MARKET-BASED EQUITY FIGURE

Relying on market capitalization is the practical means by which financial analysts commonly estimate the economists’ more theoretically rigorous definition of equity as the present value of expected future cash flows.

Market capitalization has additional advantages beyond its compara­tive ease of calculation. For one thing, it represents the consensus of large numbers of analysts and investors who constantly monitor companies’ fu­ture earnings prospects as the basis for their evaluations. In addition, an up- to-the-minute market capitalization can be calculated on any day that the stock exchange is open. This represents a considerable advantage over the shareholders’ equity shown on the balance sheet, which is updated only once every three months. Market capitalization adjusts instantaneously to news such as a surprise product launch by a competitor, an explosion that halts production at a key plant, or a sudden hike in interest rates by the Fed­eral Reserve. In contrast, these events may never be reflected in book value in a discrete, identifiable manner.

Against these advantages, however, the analyst must weigh several drawbacks to relying on market capitalization to estimate a company’s ac­tual equity value. For one thing, although the objectivity of a price quota­tion established in a competitive market is indeed a benefit, it is obtainable only for corporations with publicly traded stocks. For privately owned com­panies, the proponents of market capitalization typically generate a proxy for true equity through reference to industry-peer public companies. For ex­ample, to calculate the equity of a privately owned paper producer, an ana­lyst might multiply the publicly traded peer group’s average price-earnings ratio (see Chapter 14) by the private company’s earnings. By failing to cap­ture the impact of company-specific events, however, this approach sacri­fices one of the great merits of using market capitalization as a gauge of actual equity value.

Even if analysts rely on market capitalization exclusively in connection with publicly traded companies, they will still encounter pitfalls. Consider the case of Intel, a leading manufacturer of computer components. On May 13, 2000, Intel’s market capitalization of $407.5 billion was the third largest among the 30 companies represented in the Dow Jones Industrial Average. The following day, the Dow plummeted by 618 points, a decline of 5.7%. Intel had the dubious distinction of losing more market value on March 14 than any other company in the Dow Industrials. If the stock market was a reliable guide, then Intel’s equity contracted by 8.8%, or a staggering $35.7 billion, in a single day. Collectively, the Dow Industrials’ value fell by $227.2 billion.

Whatever theoretical arguments can be advanced in favor of regarding market capitalization as a company’s true equity value, short-run changes of the magnitude experienced by Intel on May 14, 2000, raise a caution.

An inference along those lines is supported by extensive academic re­search conducted under the rubric of “behavioral finance.” In contrast to more traditional financial economists, the behavioralists doubt that in­vestors invariably process information accurately and act on it according to rules of rationality, as defined by economists. Empirical studies by adher­ents of behavioral finance show that instead of faithfully tracking com­panies’ intrinsic values, market prices frequently overreact to news events. Even though investors supposedly evaluate stocks on the basis of exp ected future dividends (see Chapter 14), the behavioralists find that the stock market is far more volatile than the variability of dividends can explain.⁵

To be sure, these conclusions remain controversial. Traditionalists have challenged the empirical studies that underlie them, producing a vigorous debate. Nevertheless, the findings of behavioral finance lend moral support to analysts who find it hard to believe that the one- day erasure of $35.7 bil­lion of Intel’s market capitalization must automatically be a truer represen­tation of the company’s change in equity value than a figure derived from financial statement data.

Market capitalization, then, is a useful tool, but not one to be heeded blindly. In the end, “true” equity remains an elusive number. Instead of striving for theoretical purity on the matter, analysts should adopt a flexi­ble attitude, using the measure of equity value most useful to a particular application.

For example, historical-cost-based balance sheet figures are the ones that matter in estimating the risk that a company will violate a loan covenant requiring maintenance of a minimum ratio of debt to net worth (see Chapter 12).

Neither measure, however, could be expected to equate precisely to the proceeds that would actually be realized in a sale of the company. Between the time that a sale was decided on and executed, its market capitalization might change significantly, purely as a function of the stock market’s dy­namics. By the same token, the current balance sheet values of certain assets could be overstated through tardy recognition of impairments in value, or understated reflecting the prohibition on writing up an asset that has not changed hands.