You often hear companies or different mutual funds being categorized as small cap, mid cap or large cap. But what do these terms really mean? The cap is short for capitalization, which is a measure by which we can classify a company's size. Although the criteria for the different classifications are not strictly bound, it is important for investors to understand these terms, which are not only ubiquitous but also useful for gauging a company's size and riskiness.

Calculating Market Cap
Market capitalization is just a fancy name for a straightforward concept. Quite simply, it refers to the value of a company, that is, the market value of its outstanding shares. This figure is found by taking the stock price and multiplying it by the total number of shares outstanding. For example, if Cory's Tequila Corporation (CTC) was trading at $20 per share and had 1 million shares outstanding, then the market capitalization would be $20 million ($20 x 1 million shares). It's that simple.

Why Is This Important?
A common misconception is that the higher the stock price, the larger the company. Stock price, however, may misrepresent a company's actual worth. If we look at two fairly large companies, IBM (NYSE:IBM) and Microsoft (Nasdaq:MSFT), we see that at the time of writing their stock prices are $29 and $22.75 respectively. Although IBM's stock price is higher, it has about 1.73 billion shares outstanding, while MSFT has 10.68 billion. As a result of this difference, we can see that MSFT's market cap of $242.97 billion is actually considerably larger than IBM's $50.17 billion. If we compared the two companies by solely looking at their stock prices, we would not be comparing their true values, which are affected by the number of outstanding shares each company has. (The Basics Of Outstanding Shares And The Float).

The classification of companies into different caps also allows investors to gauge the growth versus risk potential. Historically, large caps have experienced slower growth with lower risk. Meanwhile, small caps have experienced higher growth potential, but with higher risk.