Many new investors are grappling with how they can assess a business’s performance and value. Two of the most commonly discussed metrics used to judge how well a company is doing and it’s worth are market capitalization, commonly referred to as a market cap, and revenue.
Understanding the difference between market cap vs. revenue and how they interact is an essential step toward becoming a successful investor.
You shall see that the market value reflects what the stock market believes a stock is worth, whereas revenue is a driver of what the business will be worth in the future.
What is Market Cap?
Market cap is the market value of all a company’s publicly traded outstanding shares. (Outstanding shares are simply the total number of a company’s shares.)
You get the company’s market capitalization by multiplying the number of outstanding shares of the company’s stock by the share price. So, for instance, Tesla has around 1 billion outstanding shares and a share price north of $1,000. Multiplying the two gives you a market value of $1 trillion.
Market cap is a constantly changing number because although outstanding share counts are relatively stable, the share price never is.
What is Revenue?
Revenue is what a business earns from sales. Tesla, for example, made over $31.5 billion in revenue in 2020.
A business’ revenue may derive from its core business (“sales,” “sales revenue,” or “operating revenue”) or non-core business activities (“non-operating revenue” or “other revenue.”
Revenue is a “top line” item because it is the first item on an income statement. This is distinct from net income (gross revenue minus total expenses), a “bottom line” item.
Research suggests that the key drivers of revenue growth are:
- Portfolio momentum. This is the organic revenue growth a company enjoys because of overall expansion in the market segments represented in its portfolio. This is the most crucial driver for large companies. In other words, being in fast-growing markets is more important than growing market share.
- Market share performance. This is the organic revenue growth (or reduction) a company earns by gaining or losing a share in any particular market.
- Mergers and acquisitions (M&A). This represents a company’s inorganic growth when it buys or sells revenues through acquisitions or divestments.
Relationship with Stock Market
The three drivers of growth create economic value to differing degrees. Benjamin Graham liked to say, “In the short run, a market is a voting machine, but it is a weighing machine in the long run.” In other words, in the short run, the market cap may be distinct from intrinsic value or what the business is worth, but the market value reflects it in the long run.
In the long run, the cap will reflect the quality of revenue growth. The more organic the revenue growth, the more value is created and therefore, the higher its value.
- There is a hierarchy of growth in which the most organic growth creates the most value. If, for example, a business launched a new product in a fast-growing market, this would create more value than if the business merged with or acquired another business.
- Revenue is a driver of value, and this will affect a business’ value.
- The market value reflects what the stock market believes a business is worth at any given time.
Why is Market Capitalization Important?
As Graham suggested, capitalization reflects what the stock market believes a company is worth at any given moment, it is simply the market value.
But, “Mr. Market” as Graham liked to say, is constantly revising his expectations and changing his mind. As a result, this value does not reflect what a business is truly worth in the short run.
For investors, this creates an opportunity. For example, suppose Mr. Market is feeling particularly pessimistic one day and suggests that a business is worth less than what it is truly worth, in other words. If the market cap is less than intrinsic value, then that is a buying opportunity. Conversely, if Mr. Market feels particularly optimistic and suggests that a business is worth more than it is, then that is an opportunity to sell or short a stock.
Market Cap vs. Enterprise Value
We suggested above that a market cap is not what a business is worth. Enterprise value is another concept that underlines this.
Enterprise value is simply what a business is worth to all its stakeholders. In other words, it is how much a business would cost if it were to be bought outright. That means all claims on cash flows have to be included in assessing its value. Not just shareholder claims, but the claims of creditors as well.
As you can see, enterprise value is a more comprehensive concept than market cap, which only considers the value of a business to its shareholders.
Investors are constantly thinking about what a business is worth. Market value reflects the opinion of shareholders and the stock market in general about a business’ worth. However, the market cap does not, in the short run, reflect what a company is truly worth. The true worth of a business, its intrinsic value influences revenue growth, and quality. The more organic growth is, the more value is added to a company. In assessing a company, investors must also consider what it is worth to all its stakeholders, not just its shareholders, and that means considering creditors.