Isn’t it crazy that a G.I. Joe action figure only cost two dollars or so in the 80s? Yet here we are, thirty-ish years after, and the same action figure sells for $280 on eBay! That’s about a 13,900% increase! Insane, right?
So, how could this happen? How can something that was bought for $2 sell for $280 years after? The simple answer would be that it has appreciated in value. Over time, the action figure has increased in value primarily because the product was considered a “collectors’ item” and as such, a lot of people (mostly loyal and diehard fanatics) would want to get a hold of this action figure (and probably brag about it on Facebook afterwards).
Not all products appreciate in value, though. Take, for instance, a car. Did you know that an average car loses approximately 11% of its value the moment you leave the dealer’s property? Shocker, right? In this example, cars have depreciated in value. Meaning, the value of the product decreases over time due to factors such as usage, wear and tear, and because new car models come out every month.
Whether a product appreciates or depreciates in value primarily depends on the law of supply and demand – which states that prices generally increase when demand is high and decrease when supply is high.
Stocks and other investments, like any other products, may appreciate or depreciate in value. Most of the time, this value is different from the book value. “The what?”, you may ask. What is book value?
What Is Book Value?
Book value is literally the value of the company as recorded in its “books” or accounting records. Book value represents the value or price paid at the time of acquisition. If we go back to our G.I. action figure example; if you happen to be one of the lucky people who purchased an action figure in the 1980s for $2, then the book value will be $2.
From a business perspective, the total book value is almost synonymous with equity. For example, Company X has total assets (everything owned by a company) of $10,000 and $4,000 worth of liabilities (everything owed by the company). The remaining value of $6,000 is the company’s equity and also its book value.
Simply put, book value is the historical value. But how do we know the “true” or “current” value of the company?
What Is Market Capitalization?
Market capitalization (market cap), also known as market value, is the total value of the business according to the stock market. So how do we know the value of market cap? It is derived by multiplying the number of stocks outstanding by the current price per share. In our G.I. Joe example earlier, the market value would be how much the action figure is worth today – $280.
Related: The Basics of the Stock Market
The total shares outstanding are the total number of shares issued by a corporation. The price per share can be derived from the current trading price of the stock in the market.
For example, Company X has 1,000 stocks outstanding. The current trading price per share in the stock market for Company X is $5. The market cap, then, is $5,000 (1,000 stocks * $5). Easy peasy!
As compared to book value, the market cap is a more reliable measurement when assessing the current value of a company. Since stocks represent partial ownership in a business, when you multiply the number of stocks by their price, the total amount represents the value that the public is willing to pay for the company.
Why the Difference?
At first glance, it may seem that book value is quite useless as it does not necessarily reflect the current value of a company. So why do we still retain the book value? Book value provides a baseline to track how much the company has increased or decreased in value.
If a company’s market value is greater than the book value, it means that the company has increased in value. In other words, the public has confidence in the earning capacity of the business and its assets. In contrast, when the market value is less than the book value, it indicates that the public has lost confidence in the company’s capability to generate future earnings and cash flows.