For investors looking to a company’s market capitalization as a measure of its worth, it can be very deceiving. That’s because they really can’t know what a company is truly worth today until they look at its total capitalization. When they do, they may realize their equity share of a company is not what the value of their shares says it is. In some circumstances, that can prove very painful for investors.
Most investors understand market capitalization because it is typically published with a company’s stock quote. It’s an easy equation to remember: Market capitalization equals the total number of outstanding shares of a company multiplied by the current share price. The heavy weighting many investors give to market capitalization may be due to the media’s fixation with it. In recent years, companies have been making news because their market capitalizations have grown to exceed the GDPs of many countries. However, any fixation on market cap could prove unhealthy for investors because it may be concealing the true health of a company.
What is Total Capitalization, and Why is it Important?
While market capitalization is a useful measure to determine which broad category of stocks a company might fit into, it falls well short in measuring the true worth of a company because it only measures equity value. It does not account for a company’s debt, represented by the bonds it has outstanding. To raise capital, companies use market capitalization – issuing stock – and — issuing bonds. Together, they represent the total capitalization of a company.
For example, a company may have $50 billion of market capitalization and $50 billion of bond capitalization for a total capitalization of $100 billion. Most investors who are only aware of the company’s market capitalization assume the stockholders have a 100% ownership share of $50 billion. That would be true if the company didn’t also have $50 billion of bond capitalization. Unfortunately, if the company went south, it would be on the hook to first pay its bondholders with whatever is left of its equity to be paid out to stockholders. So, essentially, the stockholders don’t own 100% of the company.
In that situation, it’s possible for shareholders to come out whole because there could be enough equity left after bondholders are paid. But what about a company with a market capitalization of $10 billion and bond capitalization of $90 billion. If you were only looking at the $10 billion market cap, you might think the company was a steal. But, in reality, your equity shares are only fractional based on the total capitalization of $100 billion. There would be little likelihood of receiving any value for your shares if the company was liquidated.
Tragically, such was the case in the 1980s and early nineties when thousands of investors here in Pittsburgh took advantage of what they thought was a significant opportunity. U.S. Airways was a major U.S. airline at the time selling for $2 a share and seemed to have limited downside, or so they thought. What they didn’t consider was the amount of bond capitalization the company undertook to keep its operations going. When the company went bankrupt, the bondholders took control, leaving the stockholders out in the cold.
Of course, that wouldn’t be a concern for investors who invest in companies with zero or very low debt because they would own the entire company. That’s the ideal situation and one we prefer when screening companies. However, in 2019, the average company in the U.S. was 43% capitalized by bond investments or borrowed money. That means more than half the companies have more than 43% in debt. Since companies have been taking advantage of lower rates this year, to leverage up, that number is likely much higher.
Use the Debt Filter to Find Healthy Companies
While most companies should be able to weather the current economic storm, it’s still important for investors to know where they stand on the equity ownership spectrum. And for those looking at opportunities in this market, it would be important to view companies through filters. Having set filters enables us to make primary judgments about whether to consider investing in a company. We use filters in our daily lives to make decisions that keep us out of trouble or improve our lives. For example, when choosing where to vacation by car from Pittsburgh, we might limit our choices to spots east of the Mississippi to reduce our drive time and increase our fun time. That’s a filter.
As an investor, one of our primary filters is debt as a percentage of total capitalization. Our threshold is 33% at the upper end. Except for very extenuating circumstances, we eliminate any company from consideration over that threshold. That’s our comfort level. You could have a higher or lower debt comfort level. Whatever it is, it should be the trigger for asking more questions about the company’s debt, how it’s structured, and what it means to you as a stockholder in terms of your actual ownership in the company.
