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I will try to keep this answer to your question brief.  first, because there are many financial textbooks that address your question (but they are admittedly incredibly boring), but second I'm answering the question so many days after you posted it, I'm not sure my answer will be seen.

first, understand that market capitalization means the current market estimate of the value of the company.  It is a value that is set in a very real time market place by current owners of the company (shareholders) and those that are considering buying the company (in a stock market like the New York Stock Exchange, or footsie or others).  So if you draw an analogy to selling your house, you would like to get the current market price--so shareholders would like to do the same.

Second, and here is where the value of a company on the stockmarket differs from your home, the value of the company is estimated by the market as the value of "future cash flows discounted back to the present".  So in straightforward terms, it means estimating how much money your company is going to generate in the next, let's say, 20 years, discount that back to the present, and that's the value of the company.  You may already understand the concept of "net present value", and therefore discounting cash flows, but if not, i'd suggest a google search or a text book.  I can't give a much better explanation than the fact that 1 Euro in 10 years promised to you, is worth less than 1 Euro in your hand today, because the one in your hand can be put in a bank account (or some other investment vehicle) and be worth a lot more than the promise in 10 years.  And of course the promise in 10 years is a little riskier than the Euro in your hand, because whoever gave you that promise, may be dead in 10 years and can't pay in 10 years.

So the reality is that companies are valued (ie market captialization) based on the esimate of their future earnings potential, and of course the risk of that earnings actually happening.  (If you know your Euro is in credit suisse, and will earn 3% per year, that's pretty solid.  If you're talking to a guy like me, who has a dream about his company that is wildly exciting, but risky--well, you and the market need to estimate the value of an investment in my company.  You'll probably believe I'm honest in that I'm sharing my dreams, but,,,dreams are often shattered.  so your euro in credit swisse is almost certainly worth 1.5 euros, while your euro in my start up company is worth nothing (probably) to the moon.

so this whole "market capitalization" thing comes down to an estimate of the future.  so a company that is very stable, with zero growth, may choose to pay out their earnings to the owners of the company every year in the form of dividends.  they are not growing, so they don't need the money to finance growth.  Growth companies may choose to pay no dividends to shareholders, because they see their growth opportunities as huge and want to reinvest those funds in the business.

I'll leave this for now, because I'm not sure anyone will see it.  It's like a chapter 1 (incredibly brief).  but chapter 2 would be about explaining why the growth companies need to explain their story, share their vision of the future, because they need to either raise more money, or explain to their current owners (shareholders) why they are not paying dividends, and instead reinvesting the money into their dreams.

by wchurchill on Sun Oct 23rd, 2005 at 03:41:02 AM EST
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