Market Capitalization: How Is It Calculated and What Does It Tell Investors?

Market Capitalization

Investopedia / Xiaojie Liu

What Is Market Capitalization?

Market capitalization refers to the total dollar market value of a company's outstanding shares of stock. The investment community uses this figure to determine a company's size instead of sales or total asset figures. In an acquisition, the market cap is used to determine whether a takeover candidate represents a good value or not to the acquirer.

Key Takeaways

  • Market capitalization refers to how much a company is worth as determined by the stock market. It is defined as the total market value of all outstanding shares.
  • To calculate a company's market cap, multiply the number of outstanding shares by the current market value of one share.
  • Companies are typically divided according to market capitalization: large-cap ($10 billion or more), mid-cap ($2 billion to $10 billion), and small-cap ($300 million to $2 billion).
  • Market cap is often used to determine a company's size, then evaluate the company's financial performance to other companies of various sizes.
  • In investing, companies with larger market capitalization are often safer investments as they represent more established companies with generally longer history in business.

Market Cap

Understanding Market Capitalization

Understanding what a company is worth is an important task and often difficult to quickly and accurately ascertain. Market capitalization is a quick and easy method for estimating a company's value by extrapolating what the market thinks it is worth for publicly traded companies. In such a case, simply multiply the share price by the number of available shares.

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. The market cap then becomes a real-time estimate of the company's value.

One company's share price may be $50. Another company's share price may be $100. This does not mean the second company is twice as large as the first company. Always remember to factor in the number of shares issued (and thereby analyze the company's total market cap) when analyzing securities.

How to Calculate Market Cap

The formula for market capitalization is:

Market Cap = Current Share Price * Total Number of Shares Outstanding

For example, a company with 20 million shares selling at $100 a share would have a market cap of $2 billion. A second company with a share price of $1,000 but only 10,000 shares outstanding, on the other hand, would only have a market cap of $10 million.

A company's market cap is first established via an initial public offering (IPO). Before an IPO, the company that wishes to go public enlists an investment bank to employ 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 IPO value is set at $100 million by its investment bank may decide to issue 10 million shares at $10 per share or they may equivalently want to issue 20 million at $5 a share. In either instance, the initial market cap would be $100 million.

Market Cap and Investment Strategy

Given its simplicity and effectiveness for risk assessment, the market cap can be a helpful metric in determining which stocks you are interested in, and how to diversify your portfolio with companies of different sizes.

Large-cap (aka big-cap) companies typically have a market capitalization of $10 billion or more. These companies have usually been around for a long time, and they are major players in well-established industries. Investing in large-cap companies does not necessarily bring in huge returns in a short period of time, but over the long run, these companies generally reward investors with a consistent increase in share value and dividend payments. Examples of large-cap companies—and keep in mind that this is an ever-changing sample—are Apple Inc., Microsoft Corp., and Google parent Alphabet Inc.

Mid-cap companies generally have a market capitalization of between $2 billion and $10 billion. Mid-cap companies are established companies that operate in an industry expected to experience rapid growth. Mid-cap companies are in the process of expanding. They carry an inherently higher risk than large-cap companies because they are not as established, but they are attractive for their growth potential. One example of a mid-cap company is Eagle Materials Inc. (EXP).

Companies that have a market capitalization of between $300 million to $2 billion are generally classified as small-cap companies. These small companies could be younger and/or they could serve niche markets and new industries. These companies are considered higher-risk investments due to their age, the markets they serve, and their size. Smaller companies with fewer resources are more sensitive to economic slowdowns.

As a result, small-cap share prices tend to be more volatile and less liquid than more mature and larger companies. At the same time, small companies often provide greater growth opportunities than large caps. Even smaller companies are known as micro-cap, with values between approximately $50 million and $300 million. 

Diluted Market Cap

A security's market capitalization may change over time due to the outstanding number of shares. This is especially prevalent in cryptocurrency where new tokens or coins are issued or minted frequently.

Because new offerings theoretically thin the value of existing coins, tokens, or shares, a different market cap formula can be used to calculate what the potential market cap will be should all authorized shares or tokens be issued and still be worth the current trading price. This concept is referred to the diluted market cap, and the formula is:

Diluted Market Cap = Current Share Price * Total Number of Shares Authorized

For example, consider Bitcoin trading at roughly $24,000 per coin as of mid-August 2022. At the time of writing, there are also approximately 19.1 million Bitcoin issued. However, the total number of potential Bitcoin that may eventually be minted is 21 million. Therefore, Bitcoin's market cap calculations are:

Market Cap = $24,000 * 19.1 million = $458.4 million

Diluted Market Cap = $24,000 * 21 million = $504 million

Analysts use diluted market cap to better understand potential changes to a security, token, or coin's price. For example, imagine if all 21 million Bitcoin were minted tomorrow. If it were to retain the same market cap of $458.4 million, the price would have to drop to roughly $21,828 ($458.4 million / 21 million). Therefore, companies with large inventories of unissued securities or coins are at greater risk to face price decreases if investors wish to keep its market cap the same regardless of outstanding tokens.

Misconceptions About Market Caps

Although it is used often to describe a company, the 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.

Changes in Market Cap

Two main factors can alter a company's market cap: significant changes in the price of a stock or when a company issues or repurchases shares. An investor who exercises a large number of warrants can also increase the number of shares on the market and negatively affect shareholders in a process known as dilution.

What Is Market Capitalization?

Market capitalization refers to the market value of a company’s equity. It is a simple but important measure that is calculated by multiplying a company’s shares outstanding by its price per share. For example, a company priced at $20 per share and with 100 million shares outstanding would have a market capitalization of $2 billion.

What Does a High Market Cap Tell You?

A high market cap signifies that the company has a larger presence in the market. Larger companies may have less growth potential compares to start-up firms, but larger companies may be able to secure financing for cheaper, have a more consistent stream of revenue, and capitalize on brand recognition. Though applicable to every company, companies with higher market caps are generally less risky than companies with lower market caps.

Is It Better to Have a Large Market Capitalization?

There are advantages and drawbacks to having a large market capitalization. On the one hand, larger companies might be able to secure better financing terms from banks and by selling corporate bonds. Also, these companies might benefit from competitive advantages related to their sizes, such as economies of scale or widespread brand recognition.

On the other hand, large companies might have limited opportunities for continued growth, and may therefore see their growth rates decline over time.

Does Market Cap Affect Stock Price?

Market cap does not affect stock price; rather, market cap is calculated by analyzing the stock price and number of shares issued. Although a blue-chip stock may perform better because of organizational efficiency and greater market presence, simply having a higher market cap does not directly impact stock prices.

One could argue that analysts do track market cap to determine which companies may be undervalued or overvalued. In this lens, market cap can lead an investor to buy or sell shares based on the company's relative value compared to the industry or competitors. Still, the stock price of a share is determined as the fair value determined by the market, not by a company's market capitalization.

What Is the Importance of Market Cap?

Market cap demonstrates the size of a company. It is an important tool for analytics, especially when comparing companies. Market cap is often used as a baseline for analysis as all other financial metrics must be viewed through this lens. For example, a company could have had twice as much revenue as any other company in the industry. However, if the company's market cap is four times as large, the argument could be made that company is underperforming.

The Bottom Line

Market cap can be a valuable tool for an investor who is watching stocks and evaluating potential investments. Market capitalization is a quick and easy method for estimating a company's value by extrapolating what the market thinks it is worth for publicly traded companies. The investment community uses this figure to determine a company's size, as opposed to using sales or total asset figures. In an acquisition, the market cap is used to determine whether a takeover candidate represents a good value or not to the acquirer.

Article Sources
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