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Market Capitalization Is Misleading, Use This Instead

This article is the first in a series that explains how our stock screening strategy differs from all the basic offerings out there.

How big is a company?

It's a basic question. But also a very important one.

How big a company is has a lot of bearing on investment strategy and preference. Most investors prefer larger firms, and for understandable reasons. Larger firms are more recognizable, often have competitive advantages, are are usually considered "safer" investments. On the other hand, aggressive investors looking for "home run" stocks might be more interested in smaller companies for their greater long-term growth potential.

Market Cap

Since the start of the stock market, the most common answer for "how big is a company" is market capitalization, or "market cap" in industry parlance.

Market capitalization is simply the market price of a stock (the ticker quote), times the number of shares the company has outstanding (how many "pieces of the pie" exist).

For this article, let's take two stocks currently in the Magic Recipe Spell: MKS Instruments (MKSI) and TIME (TIME). To calculate their market capitalizations (as of 2/23/16):

Market cap = Share Price * Number of Shares

MKSI = $31.98 * 54 million = $1,713 million or $1.7 billion

TIME = $13.91 * 110 million = $1,530 million or $1.5 billion

So these two companies are roughly the same size by market cap.

By the way, this also points out a common beginning investor misconception. The share price alone tells you nothing about how valuable or large a company is. MKSI's share price more than 2x TIME's, but since TIME has twice the number of shares, the two firms end up being similarly sized.

Market Cap Can Be Misleading, Here Is Something Better

As widespread and commonly accepted as market cap is, it is missing one thing.

One very big thing.

When you buy a company, as you do when you purchase a stock, you are buying both the company's assets and its liabilities.

Market Cap

This means two things. First, if a company has a lot of cash, you are really getting some of your purchase price back right away. For example, if I purchase company X for $100, but the company has $50 in the bank (and no debt), I get half my purchase price right back when I take it over. I really only paid $50 for the business itself.

On the other hand, if company X had $100 in debt and no cash in the bank, I essentially paid $200 for the business, as that $100 in debt is now my responsibility.

This is true in the stock market, too. A firm's balance sheet can dramatically change the effective price you are paying for the business itself. By subtracting the cash not needed for operations (excess cash) and adding the debt to market cap, we take this into account. This is known as the enterprise value of a company.

To illustrate the utility of enterprise value, consider our two nearly identically sized firms, MKSI and TIME. Let's calculate enterprise value for them:

Enterprise value = Market cap + Debt - Excess Cash

MKSI = $1,713 + 0 - 899 = $814 million

TIME = $1,530 + 1,371 - 48 = $2,853 million or $2.9 billion

Wow! That's quite a difference. By market cap we were paying close to the same price... even a little more for MKSI.

But when we account for the strength of the balance sheet, TIME is actually substantially more expensive - more than 3.5 times the price of MKSI! That's a HUGE difference!

Using Enterprise Value In Screening

As you can see, enterprise value is a far more telling statistic than market cap. I started with this because enterprise value is the most basic improvement used by our "Spells" to improve upon traditional stock screening techniques.

Next week, I'll show you how we can leverage enterprise value - and a few other tricks - to create a far superior stock screening statistic to the traditional price-to-earnings (or P/E) ratio.

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