Market Capitalization Formula

Market Capitalization Formula

The capital markets are important and are watched very carefully by financial managers for several reasons and use market capitalization formula. One reason is simply that companies have many direct transactions with financial markets, such as issuing their own securities, redeeming or repurchasing their own securities and investing in other companies securities. A second reason is that many of the concepts and principles that apply to financial markets are concepts and principles that managers also apply to the management of the company's real assets. Finally, capital markets provide information and signals that help managers make decisions. We further explain capital market as under.

This post describes many of these types of securities and the capital markets in which they are traded. The section also describes the roles of the professionals in the capital markets. These include a true smorgasbord of investment bankers, brokers, dealers, banks, mutual funds and other financial intermediaries.

Money Market Securities

Money market securities are short term claims with an original life that is generally one year or less. The largest markets for money market securities are for Treasury bills, commercial paper, certificates of deposit and banker's acceptances. Money market securities tend to be high grade securities with little risk of default. Because of the short time involved, the amount of interest earned simply does not allow much margin for default or for expensive credit investigations. Similarly, the securities rarely offer collateral, assets that can be claimed if the borrower defaults. The risk and amount of interest income are too small to justify the added expense involved with collateral.

Treasury Bills

A Treasury bill (T-bill) is a short term security issued by the U.S. government. The government regularly issues T-bills with original lives of 13 weeks, 26 weeks and 52 weeks. Most T-bills are sold in $10,000 at the end of its life is sold for $9400. The $600 discount is the implicit interest the investor would earn.

Commercial Paper

Commercial paper is a promissory note sold by very large, creditworthy corporations. The minimum size is typically $100,000. Lives range from 1 day to 270 days. Longer lives require registration with the Securities and Exchange Commission, which is a fairly expensive process, so corporations simply don't issue commercial paper with lives longer than 270 days. Corporations that issue commercial paper typically have a standby line of credit from a major bank. That way, if the company finds itself short of the cash it needs to redeem the commercial paper, it can quickly and easily borrow the necessary funds to fulfill its obligation.

Certificates of Deposit

Certificates of deposit (CDs) are promises to pay, written by a commercial bank or a savings bank, with lives typically ranging between six months and five years. CDs are sold at face value and pay a fixed interest rate. The principal and the last period's interest are paid to the lender at the end of the CD's life. Negotiable CDs have denominations of $100,000 or more and can be traded in the capital markets.

Bankers Acceptances

Banker's acceptances are short term loans made to importers and exporters. They help facilitate international trade. The acceptance occurs when the bank "accepts" a customer's promise to pay. The banker's acceptance is a guarantee that promises to pay the face amount of the security to whoever presents it for payment. The bank customer uses the banker's acceptance to finance a transaction by giving the security to a supplier in exchange for goods or services. The supplier can either hold the acceptance until the end of its life and collect from the bank or sell it at a discount Banker's acceptances usually have short lives (180 days or less). The security is a two party obligation, a direct customer liability and a contingent liability for the bank. Therefore, the risk of default is very low.

Bonds and Stocks

Bonds and stocks are long term securities issued by corporations or governments.

Long Term Debt

Bonds are long term debt securities. Recall that debt is a legal obligation for borrowed money. A debt security is a promise to pay interest and to repay the borrowed money, the principal, on prespecified terms. Failure to make years. Notes have lives between one and ten years. Bonds and notes are often referred to as fixed income securities, because they promise to pay specific (fixed) amounts to their owners.

Stocks 

A share of stock is equity in a corporation. Recall that equity represents ownership. Common stock is the residual interest in the company. It is residual because it is a claim on the earnings and assets of the company after all of the company's other, more senior, obligations have been met. The common shareholders have the dividend rights, voting rights, liquidation rights and preemptive rights we described in previous post Common stock does not have a fixed life.

Preferred stock also represents an equity claim. There are some important differences between common stock and preferred stock. Preferred stockholders are promised a specific periodic dividend, whereas common stockholders receive whatever dividends are decided on (perhaps none) by the board of directors of the corporation each quarter. Preferred stockholders  have a higher priority with respect to the payment of dividends and the distribution of liquidation proceeds. This means that preferred stockholders must be paid their dividends before common stockholders can be paid any dividends. However, if the company is unable to pay its preferred dividends, it cannot be forced into bankruptcy. Preferred stockholders usually do not have a residual claim on the assets of the company, as do the common shareholders. Nor do preferred stockholders normally have a right to vote on general corporate matters.

Derivative Securities

A derivative is a security that derives its value from the value of another security. Options, forward contracts and futures are among the most common derivatives.

Options

Call options and put options, which we described above with the Options Principle, are very visible examples of derivatives. For example, suppose you own a call option on a share of stock giving you the right to buy the stock at a fixed price of $20 any time during the next three months. The value of your call option depends on the value of the underlying stock. The current stock price is $15. If stock goes up to $35 per share, you can use your call option and your gain will be $15 (the $35 value of the stock minus the $20 you pay to use your call option). By contrast, if the sock stays at $15, you won't use your option to buy the stock for $20 because you can buy it for less in the market.

There are many securities with option like features in addition to puts and calls. A warrant is a long term call option issued by a corporation, giving its holder the right to buy the stock at a fixed price directly from the corporation. A convertible security gives holders the right to exchange the security for common shares.

Futures 

A futures contract is a standardized forward contract that is traded in a futures market. Standardized means that only contracts with certain features are created, such as in certain amounts and for certain time periods. A forward contract is an agreement to buy or sell something for a particular price at a future point in time. Note that a forward contract is not an option the owner has the obligation to make the transaction. Futures are traded on commodities such as corn, oil and gold. Futures are also traded on financial assets such as bonds, stocks and foreign currencies. It may seem odd at first to contract to buy something in the future. Why not simply buy it now or wait and buy it when you need it?

The answer lies in the need to plan. Suppose you don't have a way to store what you are going to need. Suppose what you are going to need has not been produced yet, as in the case of next fall's crop of corn. Market prices change according to supply and demand, so future prices may be different from what we expect. By making the contract now, we can lock in our future needs at an agreed upon price.

For example, a food packer such as Kraft Foods can plan for its needs for corn meal and farmers can sell their corn before it is harvested. This enables both parties to benefit from the Principle of Comparative Advantage. By arranging the sale purchase ahead of time, each side of the transaction can concentrate its efforts on what it does best. It need not worry constantly about what it will pay or earn for corn.

Forward contracts are also traded in private transactions. Though useful and common, such nonstandard contracts do not have the liquidity that the futures market provides.

A spot market is a market in which assets are bought and sold for immediate delivery. Some of the same assets traded in spot markets are also traded in the futures markets.

Primary and Secondary Markets

A primary market transaction involves the sale by a company of newly created securities to get additional financing. The issuing company receives the proceeds from the sale of the securities. A secondary market is a market where previously issued securities are bought and sold. The vast majority of trading in the capital markets is secondary. This is because a primary transaction takes place only once, when issued. However, those securities can be traded later many times.

Brokers, Dealers and investment Bankers

Brokers, dealers and investment bankers facilitate securities trading. Brokers and dealers assist investors in trading securities in the secondary market. A broker helps investors sell or buy securities, charging a sales commission but without taking ownership of the shares. In contrast, a dealer actually takes ownership. She buys securities for and sells them from, her own account. Suppose you buy 100 shares of Sears stock through a broker. The broker arranges the purchase from someone else, typically through a stock exchange. If instead you buy the shares from a dealer, you are buying the shares from that person.

Although some companies get additional financing by selling securities directly to investors, many others raise capital with the assistance of investment bankers. Investment bankers specialize in marketing new securities in the primary market. The people who buy the securities can be individuals or financial institutions, such as pension funds, mutual funds and insurance companies. In some cases, the investment banker act as a broker, without taking ownership of the securities. In other cases, the investment banker acts as an underwriter, who guarantees a minimum price, thereby acting, in effect, as a dealer. The first time a company issues shares to the public, it is called an initial public offering (IPO). If the company later issues additional shares to the public, such an offering is called a seasoned offering.

Financial Intermediaries

Financial intermediaries are institutions that assist in the financing of companies. Financial intermediaries include commercial banks and pension funds. They invest in securities but are themselves financed by other financial claims.

The explanation of capital market and market capitalization formula we find commercial banks invest primarily in business and personal loans and in marketable securities. They finance their assets by selling various kinds of deposits, such as checking accounts, money market accounts, savings accounts and certificates of deposit. Pension funds invest primarily in stocks, bonds and mortgages. They finance their portfolios with the cash contributions made on behalf of pension beneficiaries and keep the funds invested until it is time to pay them out as benefits. With financial intermediaries, savers are investing in securities but are doing so indirectly. Their savings are used to buy securities.