Market Capitalization

What is Market Capitalization

Market capitalization refers to the total dollar market value of a company's outstanding shares of stock. Commonly referred to as "market cap," it is calculated by multiplying the total number of a company's outstanding shares by the current market price of one share.

As an example, a company with 10 million shares selling for $100 each would have a market cap of $1 billion. The investment community uses this figure to determine a company's size, as opposed to using sales or total asset figures. In an acquisition, the market cap is used to determine whether a takeover candidate represents a good value or not to the acquirer.

Understanding Market Capitalization

Understanding what a company is worth is an important task, and often difficult to quickly and accurately ascertain. Market capitalization is a quick and easy method for estimating a company's value by extrapolating what the market thinks it is worth for publicly traded companies. In such a case, simply multiply the share price by the number of available shares. Using market capitalization to show the size of a company is important because company size is a basic determinant of various characteristics in which investors are interested, including risk. It is also easy to calculate. A company with 20 million shares selling at $100 a share would have a market cap of $2 billion. A second company with a share price of $1,000 but only 10,000 shares outstanding, on the other hand, would only have a market cap of $10 million.

A company's market cap is first established via an initial public offering (IPO). Before an IPO, the company that wishes to go public enlists an investment bank to employ valuation techniques to derive a company's value and to determine how many shares will be offered to the public and at what price. For example, a company whose value is estimated at $100 million may want to issue 10 million shares at $10 per share or they may equivalently want to issue 20 million at $5 a share.

After a company goes public and starts trading on the exchange, its price is determined by supply and demand for its shares in the market. If there is a high demand for its shares due to favorable factors, the price would increase. If the company's future growth potential doesn't look good, sellers of the stock could drive down its price. The market cap then becomes a real-time estimate of the company's value.

The formula for market capitalization is:

Market cap = share price x # shares outstanding

Market Cap and Investment Strategy

Given its simplicity and effectiveness for risk assessment, market cap can be a helpful metric in determining which stocks you are interested in, and how to diversify your portfolio with companies of different sizes.

Large-cap, or big-cap, companies typically have a market capitalization of $10 billion or more. These large companies have usually been around for a long time, and they are major players in well-established industries. Investing in large-cap companies does not necessarily bring in huge returns in a short period of time, but over the long run, these companies generally reward investors with a consistent increase in share value and dividend payments. An example of a large-cap company is International Business Machines (IBM)1, Johnson & Johnson (JNJ)2, or Microsoft (MSFT).3

Mid-cap companies generally have a market capitalization of between $2 billion and $10 billion. Mid-cap companies are established companies that operate in an industry expected to experience rapid growth. Mid-cap companies are in the process of expanding. They carry inherently higher risk than large-cap companies because they are not as established, but they are attractive for their growth potential. An example of a mid-cap company is Eagle Materials (EXP).4

Companies that have a market capitalization of between $300 million to $2 billion are generally classified as small-cap companies. These small companies could be young in age and/or they could serve niche markets and new industries. These companies are considered higher risk investments due to their age, the markets they serve, and their size. Smaller companies with fewer resources are more sensitive to economic slowdowns. As a result, small-cap share prices tend to be more volatile and less liquid than more mature and larger companies. At the same time, small companies often provide greater growth opportunities than large-caps. Even smaller companies are known as micro-cap, with values between approximately $50 million and $300 million. 

Misconceptions About Market Caps

Although it is used often to describe a company, market cap does not measure the equity value of a company. Only a thorough analysis of a company's fundamentals can do that. It is inadequate to value a company because the market price on which it is based does not necessarily reflect how much a piece of the business is worth. Shares are often over- or undervalued by the market, meaning the market price determines only how much the market is willing to pay for its shares. 

Although it measures the cost of buying all of a company's shares, the market cap does not determine the amount the company would cost to acquire in a merger transaction. A better method of calculating the price of acquiring a business outright is the enterprise value. 

Changes in Market Cap

Two main factors can alter company's market cap: significant changes in the price of a stock or when a company issues or repurchases shares. An investor who exercises a large number of warrants can also increase the amount of shares on the market and negatively affect shareholders in a process known as dilution.