Market capitalization is the aggregate market value of a company represented in 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. It is commonly referred to as "market cap," where “cap” represents capitalization - a financial term used for indicating the size of the company.
Market Cap Calculation and Example
Market cap is calculated by multiplying a company's outstanding shares by the current market price of one share. Since a company is represented by X number of shares, multiplying X with the per share price represents the total dollar value of the company. Outstanding shares refer to a company's stock currently held by all its shareholders, including share blocks held by institutional investors and restricted shares owned by the company’s officers and insiders
Market Cap = Current Market Price (per share) * Total Number of Outstanding Shares
For example, if Cory's Tequila Corp was trading at $30 per share and had a 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 also change over time. However, changes to the number of outstanding shares are infrequent, and the figure changes only when the company goes for certain corporate actions like issuing additional shares, 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.
Sizing Up Stocks: Different Types of Capitalization
Since capitalization represents a dollar value that can vary widely (from a few thousand dollars to above trillion dollars), different buckets and associated nomenclatures exist for categorizing the different market cap ranges. Following are the commonly used standards for each capitalization:
- Mega-cap - This category includes companies that have 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. For example, as of October 10, 2018, technology leader Apple Inc. (AAPL) has a market cap of $1.045 trillion, while the online retail giant Amazon.com Inc. (AMZN) stood next with $856 billion.
- Large-cap - Companies in this category have a market cap between $10 billion to $200 billion. International Business Machines Corp. (IBM) has a market cap of $130 billion and General Electric Co. (GE) has a figure of $115 billion.
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. For instance, over the last one year period ending October 10, 2018, the valuation of GE has tanked by around 45 percent, while that of Apple has risen by around 38 percent.
- Mid-cap - Ranging from $2 billion to $10 billion worth of market cap, 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 $9.52 billion and Snap Inc. (SNAP) with $8.41 billion market cap fall in this category.
- Small-cap - 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. Examples include Bed Bath & Beyond Inc. (BBBY) which has a market cap of 1.93 billion and OPKO Health Inc. (OPK) which has a market cap of $1.94 billion. Track records of such companies aren’t as long as those of the mid- to mega-caps, they present the possibility of greater capital appreciation at the cost of greater risk.
- Micro-cap - Mainly consisting 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 5-people small company working on artificial intelligence (AI)-powered robotics technology may be listed with small valuation and limited trading activity. While the upward potential of such companies is high if they succeed in hitting the bull’s eye, the downside potential is equally worse if they completely fail. Investments in such companies may not be for the faint-hearted as they do not offer the safest investment, and a great deal of research should be done before entering into such a position.
- Nano-cap – Adding another high-risk, high-reward layer beyond the micro-caps, the companies having market caps below $50 million are classified as nano-caps. These companies are considered to be the riskiest lot, and the potential for gain varies widely. These stocks typically trade on the pink sheets or 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 on a regular basis. Along with companies, other popular investments like mutual funds and exchange-traded funds (ETF) are also categorized as small-cap, mid-cap or large-cap. In case of funds, the terms represent the types of stocks in which the fund invests.
Importance of Market Capitalization
Many traders and investors, mostly the novice, often mistake the stock price to be a representation of the company’s valuation, health, and 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 and TO had a market cap of $814 billion on 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 does not give a true representation of their actual value.
With billions of dollar worth of valuation, a mega-cap or 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 on 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.
Many traders and investors, mostly the novice, often mistake the stock price to be a representation of the company’s valuation, health, and stability.
Valuations of mid-cap or small-cap companies often take the hit when there are reports of a large-cap company invading into their space of products or services. For instance, 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 than the investments in mid-cap or 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, popular market index S&P 500 index includes top 500 U.S. companies which are weighted based on their market cap value, while the FTSE 100 index includes 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 they are also used as benchmarks to track the performance of various funds, portfolios, and individual investments.
The Bottom Line
“Size Does Matter” and it does apply to the world of investing. An understanding of the market cap concept is important for not only the individual stock investor but also investors of various funds. The market cap can help the investor to know where they are putting their hard earned money.
Understanding things like market cap are important pieces to investing, but one of the first real steps is creating a brokerage investment account. Choosing a broker can be slightly intimidating with their range in prices and variety of features.