Important Business Valuation Metrics

New investors are often bewildered and confused by the financial jargon of business valuation. Confusing, strangely named ratios can simply be Greek to a newcomer to the market. Here are three of the most basic business valuation metrics used by investors that you should know.

Market Capitalization

Market capitalization is the value of a publicly traded company based on current market prices. It is calculated by multiplying all outstanding shares by the share price. For example, you start up a company called XYZ, and you divide your company into 100 publicly traded shares. One share of XYZ costs $5 per share. Therefore, your market capitalization would be $500.

There are four categories for market capitalization:

• Large Cap companies have a market cap of over $10 billion.
• Mid Cap companies have one between $2 to $10 billion.
• Small Cap companies have one between $300 million to $2 billion.
• Micro Cap companies have one under $300 million.

Market capitalization can be deceiving and must be measured in correlation to other important business metrics. Just because a company’s market cap is soaring doesn't necessarily mean that it is justified - it just means that the stock price is increasing at a rapid pace, thus increasing the company’s weight.

Price-to-Book Ratio

Let’s say your company, XYZ, has $500 in available cash. Remember that you issued 100 shares at $5 each. In this situation, the price-to-book ratio is now 1. That means that for each outstanding share, there is $5 in cash to back it up. It is calculated by dividing the share price by the cash (book) value per share. Let’s say your company’s shares increase in value to $10, but you still only have $500 in cash. Dividing $10 by $5 would now give the company a price-to-book ratio of 2.

Legendary investors such as Benjamin Graham and Warren Buffett have been followers of the book value principle. Graham famously taught that if a company is fundamentally sound and its price-to-book ratio falls below 1.0, then it is a good value investment, since logically, barring other capital losses, a company’s stock price should be worth at least its book value, if not higher.