What Is Market Capitalization?
Market capitalization, or "market cap", is the aggregate market value of a company represented in a dollar amount. Since it represents the “market” value of a company, it is computed based on the current market price (CMP) of its shares and the total number of outstanding shares. Market cap is also used to compare and categorize the size of companies among investors and analysts.
- Market capitalization is the total dollar value of all outstanding shares of a company at the current market price.
- Market cap is used to size up corporations and understand their aggregate market value.
- Companies may be categorized as large-, mid-, or small-cap depending on their market capitalization.
- Blue-chip companies are often large- or mega-cap stocks, while the very smallest are referred to as micro-caps.
Understanding Market Capitalization
Market cap is calculated by multiplying a company's outstanding shares by the current market price of one share. Since a company has a given number of outstanding shares, multiplying X with the per-share price represents the total dollar value of the company.
Outstanding shares are the total amount of shares currently held by all its shareholders, including share blocks held by institutional investors and restricted shares owned by the company’s officers and insiders.
Formula and Calculation
The formula for market cap is:
Market Cap=Price Per Share×Shares Outstanding
For example, if ABC Corp. trades at $30 per share and had one million outstanding shares, its market capitalization would be ($30 x 1 million shares) = $30 million.
Since the market price of shares of a publicly-listed company keeps changing with each passing second, the market cap also fluctuates accordingly. The number of outstanding shares can also change over time.
Note that changes to the number of outstanding shares are infrequent, and the figure changes only when the company undertakes certain corporate actions, such as issuing additional shares through a secondary offering, exercising employee stock options (ESO), issuing/redeeming other financial instruments, or buying back its shares under a share repurchase program.
Essentially, the changes in market cap are largely attributed to the share price changes, though investors should keep an eye on corporate-level developments that may change the number of outstanding shares once in a while.
Types of Market Capitalization
Since capitalization represents a dollar value that can vary widely, different buckets and associated nomenclatures exist for categorizing the different market cap ranges. Below are the commonly used standards for each capitalization.
Mega-cap companies are those with a market cap of $200 billion or higher. They are the largest publicly traded companies by market value, and typically represent the leaders of a particular industry sector or market. A limited number of companies qualify for this category.
Companies that are considered large-cap have a market cap between $10 billion to $200 billion. For example, International Business Machines Corp. (IBM) and General Electric (GE) are large-cap stocks with market caps of $125 billion and $117 billion, respectively.
Both mega and large-cap stocks are referred to as blue chips and are considered to be relatively stable and secure. However, there is no guarantee of these companies maintaining their stable valuations as all businesses are subject to market risks.
Mid-cap stocks range from $2 billion to $10 billion in market cap, and this group of companies is considered to be more volatile than the large-cap and mega-cap companies. Growth stocks represent a significant portion of the mid-caps.
Some of the companies might not be industry leaders, but they may be on their way to becoming one. Juniper Networks Inc. (JNPR), with a market cap of $9.2 billion, is one.
Small-cap companies have a market cap between $300 million to $2 billion. While the bulk of this category is comprised of relatively young companies that may have promising growth potential, a few established old businesses which may have lost value in recent times for a variety of reasons also figure in the list.
One example is Bed Bath & Beyond Inc. (BBBY) which has a market cap of $2.3 billion. Track records of such companies aren’t as long as those of the mid-to-mega-caps, but they also present the possibility of greater capital appreciation.
Companies that are considered micro-cap consist mostly of penny stocks—this category denotes companies with market capitalizations between $50 million to $300 million. For instance, a lesser-known pharma company with no marketable product and working on developing a drug for an incurable disease, or a five-person company working on artificial intelligence (AI)-powered robotics technology may be listed with a small valuation and limited trading activity.
While the upward potential of such companies is high if they succeed, the downside potential is equally worse if they completely fail. Investments in such companies may not be for the faint-hearted and require more due diligence.
Nano caps are another high-risk, high-reward layer beyond the micro-caps. Nano-cap companies have market caps below $50 million. These companies are considered to be the riskiest, and the potential for gain varies widely. These stocks typically trade on the pink sheets or Over-the-Counter Bulletin Board (OTCBB).
Historical analysis reveals that mega- and large-caps often experience slower growth with lower risk, while small-caps have higher growth potential but come with higher risk. It is common to see companies making transitions from one category to the other depending upon the change in their market cap valuations regularly. Along with companies, other popular investments like mutual funds and exchange-traded funds (ETFs) are also categorized as small-cap, mid-cap, or large-cap. In the case of funds, the terms represent the types of stocks in which the fund primarily invests.
Importance of Market Capitalization
Some traders and investors, mostly novices, can mistake a stock's price to be an accurate representation of that company’s worth, health, and/or stability. They may perceive a higher stock price as a measure of a company’s stability or a lower price as an investment available at a bargain. Stock price alone does not represent a company's actual worth. Market capitalization is the correct measure to look at, as it represents the true value as perceived by the overall market.
For instance, Microsoft with a stock price of $101.16 per share had a market cap of $814 billion as of October 10, 2018, while IBM, with a higher stock price of $142.69, had a lower market cap of $130 billion. Comparing the two companies by solely looking at their stock prices would not give a true representation of their actual relative values.
With billions of dollars worth of valuation, a large-cap company may have more room to invest a few hundred millions in a new stream of business and may not take a big hit if the venture fails. However, a mid-cap or micro-cap company making a similar value investment may be susceptible to big blows if their venture fails as they don’t have that bigger cushion to absorb the failure. If the venture succeeds for large-cap companies, it may appear small on their profit numbers. But if the company scales up with its success, it can lead to profits of larger magnitudes. On the other hand, the success of such ventures for a mid-cap company can bolster its valuations to significant heights.
A high stock price in and of itself does not always indicate a healthy or growing company. It can still have a relatively small market cap!
Valuations of mid-cap or small-cap companies often take a hit when there are reports of a large-cap company encroaching into their space of products or services. For instance, the entry of Amazon into cloud hosting services under the Amazon Web Services (AWS) umbrella has been posing a big threat to smaller companies operating in the niche space.
Generally, investments in mega-cap or large-cap stocks are considered more conservative with less volatility than investments in small-cap stocks. Though mid and small-cap stocks offer high return potential to risk-taking investors, the relatively limited resources at the disposal of such companies make their stocks more susceptible to competition, uncertainties, and business or economic downturn.
Market cap values also form the basis to launch a variety of market indexes. For example, the benchmark equity index, the S&P 500, includes the top 500 U.S. companies which are weighted based on their market cap value, while the FTSE 100 index includes the top 100 companies listed on the London Stock Exchange with the highest market capitalization.
Such indexes not only represent the overall market developments and sentiments, but are also used as benchmarks to track the performance of various funds, portfolios, and individual investments.
The Bottom Line
An understanding of the market cap concept is important for not only the individual stock investor but also investors of various funds. Market caps can help investors know where they are putting their hard-earned money.