To the uninformed observer this does not really make sense. How can a firm with such a low profit be worth so much on the stock market - Essay Example

MARKET CAPITALISATION IN RELATION TO PROFITS and MARKET CAPITALISATION IN RELATION TO PROFITS Introduction A company’s value is determined by calculating the current market value of shares held in the company. This is market capitalisation or “market cap”. On the other hand, profit is the value over and above revenues net expenses. This paper will elaborate on the link between profits and valuation in an aim to explain why a company with low profits may have very high market capitalisation.

Companies always quote a higher market capitalisation value than the actual book value that is calculated by multiplying the number of shares and the share price. This is because above the value of assets plus liabilities of a company, there is the value that the company has earned due to its existence in the market. This is known as goodwill. It is earned through a good reputation and uniqueness in brand. Contrary, profits are calculated by a net of all expenses from the revenue earned. Therefore, profits are not directly related to the market capitalisation.

According to (Market Capitalisation, 24), despite a company having high market capitalisation, it may earn low profits or even get losses. This paper examines a case study on social media company, Facebook. In the year 2012, it was estimated to have made a profit of $32m USD while its market capitalisation was estimated at $90bn USD that year in May. It is essential to make clear why such a situation would occur. In accordance to (Holtzman, Mark and Sinnet, 20), market capitalisation encompasses more than just the balance sheet items.

These other items include the market position of the company, its brand, the abilities of management and the growth potential of the company. Hence, companies may have very high market capitalisation as compared to their profits. Profits may also be quite low due to several factors such as research and development expenses and capital expenditure as claimed in (Easton et al, 12). Research and development are the costs of penetrating new markets and promotional costs while capital expenditure include costs that are incurred in a company to maintain its assets.

According to Oliver (10), profits reflect the gain that the company makes in earning revenue net all expenses. It is significant to note that the value of the company may not necessarily affect the value of profits it makes. This is since; a corporation may have invested in many assets, which are part of its market cap. However, it may not be simultaneously earning very high revenue and may be incurring very high costs to get a steady position in the market due to factors such as competition.

Hence, this explains why Facebook as a company may have been making low profits despite their market capitalisation being high. The case study on the company also shows that by December 2013, the company was worth $140bn USD, showing a significant increase in value. This may have been due to the increase in number of shares by that time as compared to the previous year before the public offering. Various companies have continued to operate in losses despite their high market capitalisation, which is not an abnormal trend.

This is because, the link between profits and market capitalisation is not a direct one. For instance, the company may have high obligations in terms of liabilities, or a high number of shares issued which increases its market capitalisation. However, the increase in the market cap does not necessarily mean increase in profits for the company as shared in (Cohen, Lauren and Karl, 34). It simply means that the company is worth a certain value but does not affect the profits directly. The only way profits would be maintained at a high level is when the company minimises its costs effectively and increases its revenue significantly.

These ways of minimising costs include opting for cheaper sources of finance, reducing capital expenditure and trimming development costs. According to (Lafley and Ram,26),increasing revenue can also be done through introducing new features in goods and services offered, creating customer loyalty and attracting more potential customers. Conclusion This paper concludes that a company’s value is not directly related to its profits. This means that a company may be making low profits as compared to its net worth.

Therefore when analysing financial information of a company it is essential to note that the profits accounted may not reflect their market capitalisation as claimed in (Smith, Gordon and Russel, 28). This is also because the two elements are affected by different factors and are calculated differently. Such that market capitalisation is affected by trends in the stock market while profits depend mainly on the costs incurred by the company. Through the critical analysis of the issue of market capitalisation in relation to profits, this paper has explained why the situation of Facebook was quite normal.

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New York: Crown Business. Market capitalisation. 2009. Mosman: IMinds. Smith, Gordon V., and Russell L., 2000. Valuation of intellectual property and intangible assets. Third Ed. New York: Wiley, Oliver, L., 2000. The cost management toolbox a managers guide to controlling costs and boosting profits. New York: AMACOM.