Defining market capitalization
The total dollar market value of a company's outstanding shares of stock is referred to as market capitalization. The size of a corporation is determined by this number rather than revenue or total assets, according to the investment community. The market cap is used in acquisitions to assess if a takeover candidate offers a good value to the acquirer or not.
Key Takeaways
- The word "market capitalization" describes a company's value as decided by the stock market. The total market value of all outstanding shares is how it is described.
- Multiply the number of outstanding shares by the share's current market value to determine a company's market capitalization.
- Market capitalization traditionally divides companies into three categories: small-cap ($300 million to $2 billion), mid-cap ($2 billion to $10 billion), and large-cap ($10 billion or more).
- Market capitalization is frequently used to establish a company's size before comparing its financial performance to that of other businesses of varying sizes.
- Because they represent more established organizations with often longer histories in operation, corporations with greater market capitalizations are frequently safer investments in the world of investing.
How market capitalization works
It's crucial to know how much a firm is worth, but it can be challenging to do so fast and accurately. By extrapolating what the market believes a publicly listed company is worth, market capitalization is a quick and simple way to calculate its value. Simply multiply the share price by the number of available shares in this situation.
After a firm goes public and begins trading on the exchange, the price of its shares in the market is determined by supply and demand. The price would rise if there is a significant demand for its shares due to advantageous reasons. Sellers of the stock may lower its price if the outlook for the company's future growth is poor. The company's value is then estimated in real-time using the market cap.
Is market capitalization important?
Market capitalization enables investors to evaluate a firm based on how valuable the general public thinks it is. The corporation appears "larger" the higher the value. When investing in a company's stock, you can expect a certain level of risk as well as potential returns on your investment based on the size and worth of the firm.
According to their market capitalizations, public firms are categorized by size:
- Large-cap ($10 billion or more)
- Mid-cap ($2 billion to $10 billion)
- Small-cap ($250 million to $2 billion)
This method of categorizing businesses aids investors in building a diversified portfolio that is optimal for long-term growth.
The key market-cap segments are broken out in more detail below, but it's crucial to keep in mind that the boundary between each segment's greater and lower value components is arbitrary. The market cap may be defined differently by indexes and fund managers, or they may utilize broader or more restrictive criteria. The share price of a company can also change significantly enough to place it in a higher or lower market-cap category.
The segments of market capitalization:
1. Large-cap: $10 billion or more
Large-cap corporations typically have a strong track record of profitability and are well-known brands, including:
- Microsoft Corp.
- Johnson & Johnson.
- JPMorgan Chase & Co.
- Exxon Mobil.
- General Mills.
- AutoZone.
- Etsy.
Large-cap corporations are often more stable because they are so well-established. They consistently pay dividends and are less likely to make headlines than some flashier equities are. According to Serina Shyu, a certified financial advisor with Delta Community Retirement & Investment Services in Atlanta, this understated character is really what attracts investors to them.
Large-cap stocks are quite monotonous, and Shyu claims that investors prefer boring equities in their portfolios. "Large-cap stock prices may rise or fall in accordance with market craziness, but not as much as compared to mid-cap or small-cap equities,"
The S&P 100 index, which includes all large-cap stocks and represents the 100 largest U.S. corporations by market cap, has an annualized 10-year total return of almost 14% right now.
Several funds, such as the iShares S&P 100 ETF, Vanguard Value ETF, and Schwab U.S. Large-Cap Value ETF, follow large-cap equities. Numerous brokerages provide tools for screening and finding additional funds that follow businesses with particular market capitalizations.
2. Mid-cap: $2 billion to $10 billion
Mid-cap companies frequently experience rapid growth, but large-cap companies have already experienced it. Additionally, with that expansion comes the possibility for both larger, quicker gains as well as potentially more severe downturns. Even though mid-cap corporations are frequently well-known names, they are typically not global behemoths like the companies mentioned above. These are a few mid-cap stocks:
- Boston Beer Company (maker of Samuel Adams).
- Cracker Barrel.
- Wyndham Hotels and Resorts.
- Dick’s Sporting Goods.
- Shutterstock.
- Asana.
Several funds, like the SPDR Portfolio S&P 400 Mid-Cap ETF and the Vanguard S&P Mid-Cap 400 ETF, aim to replicate returns that are similar to the current annualized 10-year total return of the S&P MidCap 400, an index that monitors 400 mid-cap companies.
3. Small-cap: $250 million to $2 billion
Small-cap stocks frequently represent emerging businesses with strong growth prospects. Although these stocks provide the potential for high profits (that small-cap could in fact develop into a mid- or large-cap), they also carry the risk of sizable losses.
Small-cap companies often only have a few sources of income, depend on overall U.S. economic expansion, and are more sensitive to the effects of taxes and regulations than established enterprises. Small caps are sailboats that can be rocked by a single wave, whereas large caps are massive cruise liners that can survive the roughest seas.
Nevertheless, the potential for development they offer might be advantageous to a portfolio of investors, given that the relative stability of large-cap stocks mitigates any possible downside. Examples include:
- Bed, Bath & Beyond.
- GoPro.
- Abercrombie & Fitch.
The 10-year annual return for the Russell 2000 Index, which monitors small-cap firms including all of the aforementioned, is currently at 10%. Several products, including the iShares Russell 2000 ETF and the Vanguard Russell 2000 ETF, track the Russell 2000.
4. Micro- and mega-cap
Two other market-cap classifications exist; they are known as micro-cap (below $250 million) and mega-cap (the largest companies on the stock market, some of which overlap with large-cap).
One of the most dangerous investments is micro-cap stocks. A lot of them have a remarkably poor track record, and it's likely that they don't even have any assets, operations, or income to disclose. In contrast, mega-caps represent the most reputable businesses, which frequently have large capital on hand that might support them during economic downturns.
Market capitalization – how is it calculated?
The calculation for market capitalization is as follows:
Market Cap = Current Share Price * Total Outstanding Shares
A corporation with 20 million shares trading at $100 each, for instance, would have a $2 billion market valuation. On the other hand, the market capitalization of a second business with a share price of $1,000 and just 10,000 shares outstanding would only be $10 million.
An initial public offering (IPO) is the first step in determining a company's market cap (IPO). Before an initial public offering (IPO), a company that wants to go public hires an investment bank to use valuation methodologies to evaluate the firm's value and to determine how many shares will be issued to the public and at what price.
For instance, a firm whose investment bank has set the IPO value at $100 million may elect to issue 10 million shares at $10 per share or, conversely, 20 million shares at $5 per share. The initial market valuation would be $100 million in both scenarios.
Market capitalization vs. Market value
Do you want to know how much a firm is worth? That is its market value, or what the business is actually worth.
Calculating a company's market cap is one method of determining its value for publicly traded enterprises.
Private enterprises must do a more complex (and individualized) estimate. It's unclear how much shares in private companies would be worth because they don't have publicly traded stock.
Even for publicly traded enterprises, determining market value can be difficult (i.e. what another buyer would actually pay for it). There are more techniques utilized in addition to market cap. Some involve fairly in-depth accounting, taking into account a company's liabilities, future prospects for growth, taxes, and more. These estimates occasionally also take into account more hazy analysis, such as a company's capacity for innovation and broader trends in the concerned sector. Some methods rely more on formulas and value estimation through mathematical equations. For instance, using multiples enables you to estimate a company's market worth using one of its recognized metrics.
Market capitalization and investment strategy
The market cap can be a useful metric in deciding which stocks you are interested in and how to diversify your portfolio with companies of various sizes due to its simplicity and effectiveness for risk assessment.
Market capitalizations of $10 billion or more are typical for large-cap (also known as big-cap) companies. 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.
Market capitalizations for mid-cap companies typically range from $2 billion to $10 billion. Mid-cap companies are well-established businesses that compete in a sector with high growth prospects. Mid-cap businesses are currently growing. They carry an inherently higher risk than large-cap companies because they are not as established, but they are attractive for their growth potential. Eagle Materials Inc. is one instance of a mid-cap business (EXP).
Small-cap companies are typically defined as those with a market capitalization of $300 million to $2 billion. These small businesses might be more recent start-ups or they might cater to niche markets and emerging industries. Due to their size, age, and target markets, these businesses are regarded as higher-risk investments. Smaller businesses are more vulnerable to economic downturns because they have fewer resources.
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 businesses frequently offer more room for growth than large corporations. Micro-cap firms, with values between $50 million and $300 million, are even smaller businesses.
Diluted market capitalization
The number of shares that are still in circulation might cause a security's market capitalization to fluctuate over time. This is particularly common in the cryptocurrency industry, as new tokens or coins are routinely created or issued.
A different market cap method can be used to determine what the potential market cap will be should all authorized shares or tokens be issued and still be worth the present trading price. This is because new offerings theoretically dilute the value of existing coins, tokens, or shares. The formula for this idea, known as the diluted market cap, is as follows:
Diluted Market Cap = Current Share Price * Total Number of Shares Authorized
Consider Bitcoin, which in mid-August 2022 was trading at about $24,000 per coin.
There are currently 19.1 million Bitcoins in circulation as well. However, there is 21 million possible Bitcoin that could ever be created. So, the formulas used to determine Bitcoin's market cap are:
Market Cap = $24,000 * 19.1 million = $458.4 million
Diluted Market Cap = $24,000 * 21 million = $504 million
A diluted market cap is a tool used by analysts to better understand how the price of an asset, token, or coin may vary in the future. Imagine, for instance, that tomorrow all 21 million Bitcoin were created. The price would need to decrease to about $21,828 ($458.4 million / 21 million) in order to maintain the same market cap of $458.4 million. Thus, if investors want to maintain a company's market cap regardless of the number of outstanding tokens, organizations with huge inventories of unissued securities or coins are more likely to see price declines.
Market capitalization – what are the misconceptions?
The market cap does not represent a firm's equity value, despite the fact that it is frequently used to define a corporation. That can only be done by a careful examination of a company's fundamentals. The market price on which a firm's value is based is insufficient since it may not accurately represent the value of each component of the company. The market frequently overvalues or undervalues shares; therefore, the market price simply represents what the market is ready to spend on its shares.
The market cap does not determine how much a firm would cost to buy in a merger transaction, despite measuring the price of purchasing all of its shares. The enterprise value is a more accurate way to determine the cost of buying a company entirely.
How to maintain a balance
Shyu compares managing your portfolio across companies with different market caps to making day-to-day choices, saying that if large caps are the global chain restaurants, small caps are the regional specialties that you've never heard of but that someone suggests.
"Do you like McDonald's or Joe's Burgers, which is right around the corner? Both can exist in the same planet, as well as in the same portfolio "Says Shyu. Just make sure you have the appropriate balance of each before investing a lot in one market cap or the other.
A longer timeframe gives your portfolio more time to recover from volatility, therefore in general, the riskier your allocation can be, the longer your investment horizon. Long-term investors may profit from the potential growth of small- and mid-cap companies and still have time to weather unanticipated downturns, such as those investing for a retirement that is decades away.
With a decreased allocation of small- and mid-cap stocks, investors who don't want to take on as much risk may opt to base their portfolio mostly on less volatile large- and mega-cap securities.
Market-cap information is frequently utilized to manage mutual funds as well. These funds may own shares in dozens or even hundreds of businesses, enabling investors to purchase a large number of stocks at once. Investors can purchase small-cap or large-cap mutual funds because mutual funds frequently invest by category.
FAQ
What is market capitalization?
The market value of a company's equity is referred to as market capitalization. It is a straightforward yet significant metric that is derived by dividing a company's outstanding shares by its share price. A firm with a share price of $20 and 100 million outstanding shares, for instance, would have a market capitalization of $2 billion.
What does a high market cap tell you?
A high market cap indicates that the company is more established in the industry. Although larger businesses may have less room for expansion than start-ups, they may be able to get finance more easily, generate a steadier flow of income, and benefit from their reputation. Despite being true for all businesses, those with larger market caps tend to be less risky than those with smaller ones.
Is it better to have a large market cap?
Having a huge market capitalization has benefits and limitations. Larger businesses may, on the one hand, be able to obtain better funding arrangements from banks and through offering corporate bonds. Additionally, these businesses may gain from size-related competitive advantages like economies of scale or widespread brand recognition.
On the other side, huge businesses could only have a few options to expand further, which could cause their growth rates to slow down over time.
Can market cap affect stock price?
Stock price and the number of shares issued are used to compute market cap, which has no impact on the stock price. The mere fact that a blue-chip stock has a larger market cap does not immediately affect stock prices, even though it may perform better due to organizational efficiency and more market presence.
It may be argued that analysts do monitor market capitalization to identify companies that might be overpriced or undervalued. According to this viewpoint, the market cap can influence an investor's decision to purchase or sell shares based on how valuable a firm is in relation to its sector or rivals. However, the market-determined fair value of a share, not a company's market capitalization, determines the stock price of a share.
Why is market cap important?
The market capitalization of a corporation reveals its size. It is a crucial analytical tool, particularly when comparing businesses. Due to the necessity of seeing all other financial measures through this prism, market cap is frequently utilized as a baseline for the study. A corporation might, for instance, have generated twice as much revenue as its competitors. The company might be seen to be underperforming, nevertheless, if its market cap is four times as high.