Long-term investors try to understand the relationship among company revenue, risk and potential returns in order to balance their stock portfolios. Market capitalization (market cap) is a key figure they use when deciding whether to invest in a particular company because it makes it easy to compare businesses of similar size in the same industry.
For companies considering an initial public offering (IPO), it’s important to understand market cap because analyzing comparable companies is one of several factors used to determine IPO valuation.
What Is Market Capitalization?
Market cap represents the market value of a company based on its current share price and the total number of its outstanding shares. Market cap provides a convenient way to track and compare publicly traded companies based on their valuation. Comparing the market caps of similar companies and help investors decide whether a given company is overvalued, valued correctly or undervalued by the market.
There are three primary market cap categories: large-cap, for companies valued at $10 billion or more; mid-cap, for companies valued between $2 billion and $10 billion; and small-cap, for companies valued roughly from $300 million to $2 billion. These market cap sizes have traditionally also corresponded to a company’s stage of development, but nowadays this is far less true. Especially for companies in industries such as information technology and biotechnology, there is a growing incidence of high valuations that are out-of-proportion to the company’s maturity.
Because a company’s market cap is determined by its share price, it represents investors’ perceived value of a business, rather than its book value. It reveals how much investors are willing to pay for the company’s stock and, as such, the company’s susceptibility to economic headwinds is “priced in.”
Still, market cap doesn’t tell the whole story of a company’s value. Companies with similar market caps may have different price-to-earnings (P/E) ratios, as well as dissimilar levels of outstanding debt or authorized shares that have not yet been sold to the public. Market cap also leaves out considerations like present and future cash flow and the resale value of company assets. A company with a market cap much lower than its resale value could be a target for a takeover.
In general, the higher a company’s market cap, the more it can benefit from greater coverage by stock analysts and more access to loans for reinvestment. The higher the valuation, the more likely the business has capital to deploy and invest in future growth.
Key Takeaways
- Market cap is a measure of value used to analyze and compare similar stocks.
- Market cap is simply the total value of all of a company’s outstanding shares, so it reveals how much investors are willing to pay for a stock.
- Mutual fund portfolio managers and other investors use market cap as a standard way to categorize investments and compare the performance of similar investments.
- Market caps are classified by size/dollar value (small, medium and large), which historically has corresponded to a company’s stage of development. But this relationship has decreased over time.
- For companies that are preparing to go public, understanding market cap can help them estimate the amount of capital they might be able to raise.
Market Cap Explained
Market cap is one of many measures investors use to evaluate the size of a company and where it is in its development. Businesses also use market cap to assess targets for their acquisition and partnering strategies and as a factor in their own investment planning. Stock indexes and investment funds group companies together by market cap for comparison purposes and to provide investors with options for portfolio investment strategies. Market cap is particularly helpful for diversifying investment portfolios to reduce the impact of a decline in one market cap category. For example, last year the Dow Jones U.S. Large-Cap Growth Total Stock Market Index was down 30.88% year-to-date (YTD) as of late October 2022, while its small-cap counterpart was down only 23.58% — a significant difference for investors.
Many factors can influence a company’s market cap, including changes in share value, the number of shares issued or an exercise of warrants that increases the number of outstanding shares. Stock splits or the issuance of dividends do not typically alter a market cap since, in both cases, the increase in shares offered is accompanied by a price drop. For example, in the case of a 2-for-1 stock split, the share price is halved.
Importantly, market cap doesn’t necessarily reflect how much a business is actually worth because it doesn’t account for certain crucial factors, such as a company’s cash reserves or debt. Another calculation, called ” enterprise value,” better represents the total value of a company and is defined as its market cap plus outstanding debt minus available cash. Enterprise value is used to calculate the potential cost to acquire a company and to compare the relative performance of different companies.
How to Calculate Market Cap
Market capitalization is calculated by multiplying the number of a company’s outstanding shares times the current market value of one share. The formula is:
Market cap = price per share x shares outstanding
For example, a company with 30 million shares currently selling at $100 per share has a market cap of $3 billion, while another company with 20,000 shares selling at $1,000 per share has a market cap of $20 million. If you looked only at their per-share prices, you wouldn’t know the first company was the more highly valued of the two. Investors often consider companies with larger market caps to be safer investments over the long run.