Everything you need to know about market cap
Don’t be fooled by the popular opinion that market capitalization reflects the real value of a company. It doesn’t.
Keep reading to find out why that’s the case—and how to calculate and use market cap in practice to your best advantage.
Market capitalization is easy to calculate using the simple formula as follows:
Market capitalization is calculated by multiplying the number of stock shares a company has outstanding by the current market price of one stock share.
As an example, if a company has 1 million shares currently held by shareholders, and the current share price is $1, then the company’s market cap is $1 million.
Now, compare the following companies with wildly different stock prices and outstanding number of shares:
| Market Cap Examples | Outstanding Stock | Stock Price | Market Capitalization |
|---|---|---|---|
| = number of shares outstanding | = closing market price per share | = share price X number of shares | |
| Company A | 300 million | $10 | $3 billion |
| Company B | 20 million | $100 | $2 billion |
| Company C | 10 million | $100 | $1 billion |
| Company D | 1 million | $50 | $50 million |
| Company E | 10,000 | $1,000 | $10 million |
Isn’t it interesting? If you looked at their per-share prices alone, you would have no idea that Company A was in fact the most highly valued of them all.
That is why when you’re evaluating publicly traded companies (e.g., to purchase shares), you shouldn’t focus just on the price of an individual share.
It’s like comparing apples and oranges.
Rather, make sure you consider its market cap as well, to get a more holistic picture of how the market values the company overall.
Not all of the outstanding shares of a company trade freely on the open market. Part of the stock is typically locked-in, including shares held by institutional investors, governmental bodies and company executives.
The shares available for trading on the open market by the general public are called the float.
Hence, the float-adjusted free-float calculation considers only the floating number of shares, generally resulting in a smaller market cap number, which provides a more accurate view of how the market values a company’s stock. This is why the float-adjusted free-float market cap is used by many major indexes, funds and other investors.
By now you’re probably wondering:
There are four main reasons why market cap is so popular and widely used:
1. Quick Estimate
Given the simplicity of its calculation, market cap is an easy method to get a quick estimate of a company’s value by extrapolating what the market thinks it is worth.
2. Public Perception
Since the market cap calculation is based on the price of shares publicly traded on the open stock markets, it reflects what investors are willing to pay for the shares.
It follows then that capitalization is used as an indicator of opinion on company’s value in the open market, including both the current worth and future prospects of the business.
3. Size Comparison
Based on how valuable the public perceives it to be, market cap allows investors to determine the relative size of a company and compare it to another, for example in a particular industry or sector.
4. Risk Diversification
Using market capitalization to size up companies is important because investors understand the relationship between company size and the potential for return and risk. Categorizing companies this way helps them build a portfolio that’s optimized for their diversification criteria.
These are the 5 most common ways in which the investment community makes use of the market cap calculation:
1. Investors
Investors, individual and institutional, can use market capitalization as one of many factors in stock valuation and determining a prospective purchase of shares.
2. Funds & Indexes
Indexes, funds and other entities that track, analyze, hold and transact with stock of a large number of companies in bulk can do so by market cap category (e.g., small/mid/large-cap).
3. Mergers & Acquisitions
In an acquisition or merger scenario, the market cap figure can be applied as one of the criteria to determine whether the takeover prospect is of an appropriate size and value for the acquirer.
4. Stock Exchanges
The investing community uses size ranking by market cap not only for stocks, but also for the stock exchange themselves— totalling the market caps of all companies listed on a stock exchange—and even for entire economic regions.
These capitalization of stock markets and economic regions can then be compared with other economic indicators.
5. Accountants
Accountants may also sometimes use market cap as a basis for their calculations to comply with the relevant regulatory requirements regarding financial statements and the associated disclosures.
Companies are generally categorized into six group segments according to their market capitalization size:
| Market Capitalization Segmentation | |
|---|---|
| Type of Stock | Market Cap Size Range |
| Mega cap | More than $100 billion |
| Large cap (Big cap) | $10 billion to $100 billion |
| Mid cap | $2 billion to $10 billion |
| Small cap | $500 million to $2 billion |
| Micro cap | $50 million to $500 million |
| Nano cap | Less than $50 million |
In general, market capitalization corresponds to the stage of company’s business development.
Traditionally, companies used to be divided into large-cap, mid-cap, and small-cap.
The terms mega-cap and micro-cap have also became common since. Nano-cap is a relatively new label.
Naturally, a company can move from one market-cap category to another if its share price fluctuates significantly enough.
Keep in mind that these classifications are only approximations and general best-practice guidelines. There is no official classification system or consensus agreement around the categories and thresholds.
In fact, the investment world uses a wide variety of market cap definitions and criteria, for example:
In summary, the definitions presented here are fluid at best.
Examples of large-cap companies include:
The vast majority of large-cap companies are brands known worldwide that have been around for a long time and positioned themselves as the leaders in their established industries.
Since big-cap stocks tend to belong to reputable, mature and strong companies, they are generally less volatile and sensitive to market movements, economic and industry cycles, as well as competitive threats compared to mid-cap or small-cap stocks.
As a result of the companies, as well as their respective industries, being so well established and stable, they typically have a history of rewarding investors with steady growth, consistent increase in share value, and reliable dividend payouts over the long run.
In fact, big caps are often where you’ll find the best dividend stocks. This is because large companies often generate more cash than they need for running and growing their business, and return that excess capital to investors in dividend payments.
On the other hand, investing in large-cap companies does not necessarily bring in huge returns in a short period of time and their growth prospects may potentially be limited due to their maturity.
All in all, investments in large-cap stocks may be considered more conservative than investments in small-cap or mid-cap stocks, presenting the investor with less risk in exchange for less aggressive potential for growth and price appreciation.
Examples of mid-cap stocks include:
Mid-cap stocks belong to medium-sized companies that are also established, and can even be a household name, but they operate within industries experiencing, or expected to experience, rapid growth.
As such, mid-cap companies are in the process of expanding, increasing market share and improving overall competitiveness.
This growth phase will determine whether a company eventually lives up to its full potential and reaches the large-cap stage.
In terms of risk versus return, mid-cap stocks generally fall between large-caps and small-caps.
Mid-caps are often growth-oriented stocks, which generally promise more growth potential than large caps, and potentially pose less risk than small-caps.
While large-cap companies have probably already seen rapid growth, mid-caps are right in the middle of it. With that growth potential comes the opportunity for higher and faster gains that makes mid-cap companies attractive to investors.
Mid-cap companies have already made significant progress in creating successful business models, which gives investors some protection against the price volatility small-cap companies often face.
Despite some track record of success, mid-caps still face the challenge of competing with large-cap companies, which are larger, better known and funded.
Moreover, they carry inherently higher risk than large-caps because the companies and their industries are not as established and stable.
So all that attractive growth potential is coupled with higher sensitivity to volatility and downturns in the economy, industry and market.
Also, not all mid-caps are growth stocks. For instance, they could be former large-caps that have declined over time (e.g., due to competitive pressures), or companies without significant growth prospects (e.g., due to the niche they operate in).
Mid-cap stocks typically fall in between small caps and large caps in terms of investment growth potential and safety considerations.
Examples of small-cap stocks include:
Small-caps tend to be ‘high-risk & high-return’ stocks issued by younger companies that serve niche markets or new emerging industries with the potential for high growth.
Generally speaking, these stocks of smaller companies have greater potential for price growth and high return opportunities than mid-caps, and especially large-caps, because they have more room to grow.
Naturally, there is always the possibility that a small-cap could grow into a mid-cap or even a large-cap company.
Although many fail to live up to the expectations, the category of small-cap stocks as a whole has historically delivered above-average returns to investors.
Out of the three main cap categories, small-cap stocks are considered to be the most aggressive investment with the highest level of risk, due to the uncertainty over their future performance, resulting from the age and size of these companies, as well as the markets they serve.
Compared to larger, more mature and established companies, small caps have a number of added risk factors, including:
These risk factors leads to the following disadvantages for investors:
The possibility of high returns comes hand-in-hand with higher odds of failure.
Even smaller companies with market cap below $500 million are either categorized within the small-cap segment itself or separately as micro-cap stocks.
Often referred to as “penny stocks”, nano cap companies are considered the smallest stocks by market cap.
Due to their size, stability, and potential for manipulation, nano-caps are considered highly risky investments. This makes them popular with traders who have high risk appetite and desire to capture aggressive short-term growth in exchange for adequately high risk of failure.
If large-caps are like battleships that can endure the choppiest waters; and small-caps are sailboats that can be sunk by one single wave; then micro-caps are inflatable kayaks; which makes nano-caps surfers on paddleboards.
Lastly, nano-caps are not as strictly regulated as larger stocks, which makes them susceptible to issues like “pump and dump” schemes or non-compliance with reporting and auditing requirements.
The biggest misconception (and my personal pet peeve) about market cap is that it measures what “company is worth” and is the same thing as enterprise value.
Nothing is further from the truth.
So let’s clear this up once and for all.
Both market capitalization and enterprise value are commonly used measures of a company’s market value, which can be used for competitive comparison, investment decision-making, or determination of a fair price to pay for stock shares. But each takes a different a road to that destination.
As a share price multiplied by the number of outstanding shares, market cap presents us with two shortcomings when it comes to market valuation of a company:
| What Market Cap Represents | Shortcomings of Market Cap Valuation |
|---|---|
| Value of company’s equity | Comprehensive valuation of a business should take into consideration both equity and debt capital of an entity. |
| Total price amount required to hypothetically buy up all of the company's shares on the stock market. | Shares are either over or undervalued by the market, meaning the market price determines only how much the market is willing to pay for its shares—not the true total value or “worth” of the enterprise. |
In contrast, enterprise value is a more complex analysis of the total value of a company, its ‘worth’, including equity as well as debt.
So, market cap is about price—what you pay for something, but enterprise value is about value—what you get for that price.
For example:
Let’s imagine that a value of an apple is $1. It is a special variety grown in an organic orchard.
To sum up:
Market cap is concerned with the most recent market share price of a company, it is not about the true value of what the business is worth overall.
These are the four steps to calculate an enterprise value of a company:
The cash is deducted because in an actual merger or acquisition scenario, the acquirer would take possession of the target company’s cash, so it needs to be excluded from the acquisition price.
Did you know that market capitalization is also sometimes referred to as market value, equity value or even equity market value?
Market capitalization measures the value of a company’s equity—it’s stock shares—and so can also be referred to as its equity value.
The terms market capitalization and market value tend to be used interchangeably in the context of a company, because both represent the value of a business according to the stock market.
Given its simplicity, market cap can be a helpful metric for quickly assessing risk and spotting opportunities in the market—to determine which stocks you may want to include into your portfolio, and how to diversify it with market caps of different sizes.
In order to build an investment portfolio with the appropriate mix of small-cap, mid-cap, and large-cap stocks, you’ll need to evaluate your financial goals, time horizon and risk tolerance.
In any case, however, keep in mind that diversification does not entirely eliminate risk.
Sign up for our Newsletter
Get more articles just like this straight into your mailbox.
Related Posts
Recent Posts