The below screenshot of Commonwealth Bank of Australia's (CBA) details were taken from the Google Finance website on 7 Nov 2014. Some information has been deliberately blanked out.
What was CBA's market capitalisation of equity?
The market capitalisation of equity ##(E)## equals the number of shares ##(n)## multiplied by the market share price ##(p)##.
###\begin{aligned} E &= n.p \\ &= 1.62b \times 82.76 \\ &= 134.07b \\ \end{aligned}###The below screenshot of Microsoft's (MSFT) details were taken from the Google Finance website on 28 Nov 2014. Some information has been deliberately blanked out.
What was MSFT's market capitalisation of equity?
The market capitalisation of equity ##(E)## equals the number of shares ##(n)## multiplied by the market share price ##(p)##.
###\begin{aligned} E &= n.p \\ &= 8.24b \times 47.81 \\ &= 393.95b \\ \end{aligned}###Which of the following statements about book and market equity is NOT correct?
The statement in answer C is untrue. A company's book value of equity is recorded in its balance sheet, also known as the statement of financial position.
Question 461 book and market values, ROE, ROA, market efficiency
One year ago a pharmaceutical firm floated by selling its 1 million shares for $100 each. Its book and market values of equity were both $100m. Its debt totalled $50m. The required return on the firm's assets was 15%, equity 20% and debt 5% pa.
In the year since then, the firm:
- Earned net income of $29m.
- Paid dividends totaling $10m.
- Discovered a valuable new drug that will lead to a massive 1,000 times increase in the firm's net income in 10 years after the research is commercialised. News of the discovery was publicly announced. The firm's systematic risk remains unchanged.
Which of the following statements is NOT correct? All statements are about current figures, not figures one year ago.
Hint: Book return on assets (ROA) and book return on equity (ROE) are ratios that accountants like to use to measure a business's past performance.
###\text{ROA}= \dfrac{\text{Net income}}{\text{Book value of assets}}###
###\text{ROE}= \dfrac{\text{Net income}}{\text{Book value of equity}}###
The required return on assets ##r_V## is a return that financiers like to use to estimate a business's future required performance which compensates them for the firm's assets' risks. If the business were to achieve realised historical returns equal to its required returns, then investment into the business's assets would have been a zero-NPV decision, which is neither good nor bad but fair.
###r_\text{V, 0 to 1}= \dfrac{\text{Cash flow from assets}_\text{1}}{\text{Market value of assets}_\text{0}} = \dfrac{CFFA_\text{1}}{V_\text{0}}###
Similarly for equity and debt.
The statement in answer A is untrue. The book value of equity would have grown from $100m to $119m (=100m + 29m - 10m) due to the addition of earnings and the subtraction of dividends.
The market value equity would be much higher due to the discovery of the valuable new drug which will increase the firm's future earnings and cash flows. This will cause a large increase in the share price, much higher than the $19m increase in book equity.
Notice that book equity is affected by events in the past, while market equity is only affected by what is expected to happen in the future. This is the fundamental difference between book (accounting) values and market (finance) values.