What Is Market Capitalization?

UTC by Andy Watson · 8 min read
What Is Market Capitalization?
Photo: QuoteInspector

Market capitalization is widely talked about, but how much do you actually know about it? Our guide will equip you with the most essential knowledge.

In the world of finance, there is a plethora of investment options for all types of consumers. Some of the stock is more secure, while the other involves a higher degree of risk and volatility. Depending on your confidence, you may opt for large well-established companies or rather go in favor of innovators and game-changers. And market value of a company – market cap – can be a good start for the basis of your decision.

What Is Market Capitalization?

As comes from the definition, market capitalization (also known as market cap) is a multiple of the total number of company’s shares outstanding by the current market price per share. It is used as a reliable metrics to find the total market value of a company, since it tells how much money would be needed to purchase all company’s stock circulating on the market. Market cap is also used by investors as a determinant of a company’s size and helps in comparing one company versus another.

Market cap is rather different from another metrics, which is known as free-float market cap. While the former takes into account all shares circulating on the market, free-float market cap considers only outstanding shares accessible for the general public. This way, the indicator excludes locked-in shares reserved by company executives or governance. Free-float market cap is used by major indexes like S&P 500 and Dow Jones Industrial Average since it gives a realistic estimate and helps to form a more accurate picture of the company’s market worth.

Understanding Market Capitalization

Market cap is fairly easy to calculate if two variables – the number of outstanding shares and the price of one share – are known. Let’s assume that company A has a total of 20,000 shares outstanding, each traded at the price of $10. Then market cap would be obtained by multiplying the two, which is equal to $200,000.

Overall, market cap is more easily applicable to public companies than private. In case of former, the price of stock is settled by the stock exchange and reflects the value on the market. With private companies that have no stock listed, there is no one clear estimate for price but, rather, there are different approaches to value the company. One common way is to compare private company against the most closely resembling public one. Other ways include employing equity valuation metrics (such as price-to-earnings, price-to-free cash flow, price-to-sales, and price-to-book) and estimating discounted cash flow.

So why is market cap so important? First of all, it tells you the company’s size and is therefore used as a benchmark for comparing one company against another. Second, it also brings you the knowledge on perception of a company by investors, since the stock price reflects how much investors are willing to pay – and, therefore, how much confidence they place in a given company.

Market cap can be impacted by a number of factors, both internal and external. Those can be:

  • Change in the value of shares. If for one reason or another the share price changes in a positive side or reverse, the market cap will be the first one affected. Such changes usually take place when a company makes some major important announcement that will affect the course of work, or are provoked by the external macroeconomic situation.
  • Increase in the number of shares outstanding. When the company decides to fuel more shares into circulation, the price of one share goes down. This happens because the company’s market value is unchanged in the short run, but of course, some changes may take place in a course of a longer time period.
  • Share splits. If a company takes the decision to split its existing shares 2 for 1, the number of them doubles. This causes stock to go down, since with more shares on the market having the same cumulate value the price of one share will invariably be halved.
  • Issue of dividends. While the price of a stock may increase because of dividend payments, it also has the opposite effect on share’s price. When issuing dividends, the company increases the number of shares outstanding, thus deluding the value per one share and causing the stock price to go down.

Market Cap by Size

To have a better feeling of market environment, investors are using market cap to estimate the size of the individual players. Generally, there are three types of companies by market cap:

  • Small-cap companies have up to $2 billion in market cap. The major part of those are newly established businesses that have a growth potential in the upcoming years. Besides, a part of it is also businesses successful in the past that for some reason lost significantly their share value. Small-cap companies illustrate attractive future perspectives that comes at the expense of higher risk.
  • Mid-cap companies possess market cap worth from $2 billion to $10 billion. These are the companies with more volatile stock than of large-cap companies. However, this is offset by high growth potential reflected in stock. Mid-cap companies may not be the industry leaders at this point of time, but they are on the way to becoming one. According to a recent study, this type of companies actually outperforms small-cap and large-cap peers within the recent 20 years.
  • Large-cap companies have less than $1 billion in market cap. These can be considered as the safest investment options since they are least exposed to the financial risk and are most likely to pay dividends. However, the return on large-cap companies may not be the same as on more risky stock.

In order to build a sound financial portfolio, it is recommended to apply a mix of all the abovementioned types. This will help to mitigate risk and improve returns, which will eventually help you to fulfill your financial goal. However, for that to work out, first it is important to define your financial goals, evaluate risk tolerance and establish time horizon. Only after that, a proper mix of market caps can be picked up.

Misconceptions about Market Caps

According to the definition, market cap shows the company’s monetary value on the open market. It also shows investors’ expectations that are reflected in the share price – the more investors are willing to pay, the higher share price is – and the opposite. But does market cap reflect the real value of a company?

There is no straightforward answer. But most likely, the worthiness of the company will be much more complex to define than its value on paper. As a matter of fact, market cap shows only the total amount you would have to pay if you want to purchase the company in a single transaction. However, that’s only one part of a whole, since market cap does not shed the light on company’s internal situation, but rather only reflects the value other people on the market assign to it.

The true value of a company as itself is much more difficult to assess. In order to arrive to a viable solution, investors are often basing their choice on the analysis of fundamentals, such as price-to-earnings and return-on-equity. Interest rates, corporate debt, and long-term growth potential are also taken into account and play a significant role while deciding which company to invest.

These factors give a more comprehensive overview as opposed to market cap alone, which may change under the pressure of bear market or recession. It is also not uncommon that the company gets either overvalued or undervalued on the market – in the former case, a good investor would sell the stock, while in the latter would opt for buying. However, that alone could not be told from market cap, but rather from fundamental analysis.

In short, market cap may be the fastest way to get a snapshot of a company’s position on the market, but insufficient to make a center of your financial decision.

Top 10 Largest Companies by Market Cap

By the time of writing this guide (November 24th, 2019), these are the largest companies in the world based on market cap (USD):

Apple1.183T
Microsoft1.141T
Alphabet892.963B
Amazon.com865.523B
Facebook566.985B
Berkshire Hathaway533.034B
Alibaba487.655B
JPMorgan Chase410.22B
Tencent Holdings404.531B
Johnson & Johnson363.382B

The leadership positions are taken by big tech companies. All blue-chip corporations included into FAANG (Facebook, Apple, Amazon, Netflix, and Google) can be found on the list, with the exception of Netflix.

Summary

To sum up, market capitalization is valuable metrics that helps to know how much a given company is worth on the market. Understanding this may help you to benchmark the company against other players on the market. Popular market indexes such as S&P 500 are also including market cap as a way to measure a company’s size and importance on the market. However, market cap should be used carefully in financial decisions and not overestimated, since it tells more about market perception of a company rather than its true value.

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