Market capitalization refers to the total dollar market value of a company's outstanding shares. Colloquially called "market cap," it is calculated by multiplying the total number of a company's shares by the current market price of one share. The investment community uses this figure to determine a company's size, and basically how the stock market is valuing the company.
Popular valuation ratios that take market capitalization include:
- Price-to-earnings ratio: calculated by dividing market cap by 12-month net income; can reference trailing earnings or projected future earnings
- Price-to-free-cash-flow ratio: calculated by dividing market cap by 12-month free cash flow (derived by subtracting capital expenses from cash flow from operations; can also use historical or projected returns
- Price-to-book value: calculated by dividing market cap by total shareholder equity (the balance of total assets and liabilities).
- Enterprise-value-to-EBITDA (earnings before interest, taxes, deprecation and amortization): functions similarly to the price to earnings ratio; enterprise value is calculated by totaling the market value of common and preferred equity, minority interest and net debt. EBITDA measures operational returns in the short term.
There is no official barrier for different categories of stocks based on size, but large caps are often companies with market caps over $10 billion, while mid caps are $2 billion to $10 billion, and small caps are under $2 billion.
Market capitalization is used to set investor expectations and shape investment strategy. Different types of investment strategies focus on the various market cap groups, and different valuation methods are applied depending on company size. Very large market caps are usually associated with mature, low-growth companies that pay dividends. Small caps are often growth companies with higher-risk profiles and generally do not pay dividends.