A company's worth—or its total market value—is called its market capitalization, or "market cap." A company's market cap can be determined by multiplying the company's stock price by the number of shares outstanding.
The stock price is a relative and proportional value of a company's worth. Therefore, it only represents a percentage change in a company's market cap at any given point in time.
Any percentage changes in a stock price will result in an equal percentage change in a company's market cap. This is one of the main reasons why investors are so concerned with stock prices; for example, a $0.10 drop in the stock price can result in a $100,000 loss for a shareholder with one million shares.
- A company's market capitalization—also called its "market cap"—is a measure of what a company's market value is.
- Market cap is calculated by taking the current share price and multiplying it by the number of shares outstanding.
- For example, a company with 50 million shares and a stock price of $100 per share would have a market cap of $5 billion.
- Stocks are often classified according to the company's respective market value; "big-caps" refer to company's that has a large market value while "small-caps" refer to a company that has a small market value.
How Is Share Price Determined?
Generally speaking, the prices in the stock market are driven by supply and demand. This makes the stock market similar to other economic markets. When a stock is sold, a buyer and seller exchange money for share ownership. The price for which the stock is purchased becomes the new market price. When a second share is sold, this price becomes the newest market price, etc.
There are specific quantitative techniques and formulas that can be used to predict the price of a company's shares. Called dividend discount models (DDMs), they are based on the concept that a stock's current price equals the sum total of all its future dividend payments (when discounted back to their present value). By determining a company's share by the sum total of its expected future dividends, dividend discount models use the theory of the time value of money (TVM).
In simple terms, the stock price of a company is calculated by multiplying its share price by the number of shares outstanding:
Market Capitalization = share price x number of shares outstanding
A company's market cap is first established in an event called an initial public offering (IPO). During this process, a company pays a third party (typically an investment bank) to use very complex formulas and valuation techniques to derive a company's value. They also 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.
After a company goes public, and its shares start trading on a stock exchange, its share 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 will increase. If the company's future growth potential doesn't look good, sellers of the stock can drive down its price.
For example, suppose that Microsoft (MSFT) is trading for $71.41 on a particular day, and has 7.7 billion shares outstanding. Assume also that the company is valued at $71.41 x 7.7 billion = $550 billion. If we take this one step further, we can see that Facebook (FB), which has a $167.40 stock price and 2.37 billion shares outstanding (market cap = $396.7 billion) is worth less than a company with a $71.41 stock price and 7.7 billion shares outstanding (market cap = $550 billion).
Misconceptions About Market Capitalization
Although it is used often to describe a company (e.g. large-cap vs. small-cap), market cap does not measure the equity value of a company. Only a thorough analysis of a company's fundamentals can do that. Market capitalization is an inadequate way to value a company because the basis of it market price does not necessarily reflect how much a piece of the business is worth. Shares are often over- or undervalued by the market; the market price determines only how much the market is willing to pay for its shares (not how much it is actually worth).
In addition, although it measures the cost of buying all of a company's shares, the market cap of a company does not determine the amount the company would cost to acquire in a merger transaction.
While market cap is often used synonymously with a company's market value, it is important to keep in mind that market cap refers only to the market value of a company's equity, not its market value overall (which can include the value of its debt or assets).