What Is a Company's 'Market Cap'?
Thus, the stock price is a relative and proportional value of a company's worth and only represents percentage changes in 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 value. This is the reason why investors are so concerned with stock prices and any changes that may occur since a $0.10 drop in stock can result in a $100,000 loss for shareholders with one million shares.
- A company's market capitalization, or "market cap", is a measure of what it is 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 market caps, from big-caps to small-caps.
How Is Share Price Determined?
Generally speaking, the stock market is driven by supply and demand, much like any market. 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 quantitative techniques and formulas 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).
How is Market Cap Calculated?
The next logical question is: Who sets the stock prices and how are they calculated? 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 # shares outstanding
A company's market cap is first established in an event called an initial public offering (IPO). This is when a company pays an investment bank to use very complex formulas and 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 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.
For example, if Microsoft (MSFT) is trading for $71.41, on a particular day, and has 7.7 billion shares outstanding, 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) that 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 Cap
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. 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 (EV)
Market capitalization is often synonymous with a company's market value— But be careful, since 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.
(For more information on market capitalization & investing, read: Understanding Small- And Big-Cap Stocks.)