Companies are often grouped together in stock market research by market capitalization. But what is this, and why is it significant?
The term market capitalization is used to describe the dollar value that investors assign to a company’s outstanding shares of stock. This number, rather than sales or total assets, is used by the investment community to gauge a company’s size.
Market capitalization is one of the most important metrics for investors to consider, but it’s often misunderstood.
As such, in this article we’re going to break down this metric in a way that makes sense to everyone.
What is market capitalization?
Market capitalization is a key metric in the financial world. It’s used to compare companies on one stock exchange, as well as across industries and against competitors.
For example, if you want to know how large a company is relative to its peers or if you want to see how your favorite company stacks up against other companies of similar size.
Market capitalization can help you do that by providing an apples-to-apples comparison of market value (the price at which shares are being bought and sold).
The market capitalization of a company is used in an acquisition to evaluate whether or not it is a good value.
The market capitalization of a company is the total dollar value of its outstanding shares. It is calculated by multiplying a company’s shares outstanding by its share price.
The number of outstanding shares represents the total number of shares held by shareholders as of a given date. This includes both publicly traded shares and restricted stock owned by company insiders and officers.
For example, if you own 100 shares of Company XYZ and its stock price is $10 per share, your investment has a market capitalization of $1,000 ($10 x 100).
If Company XYZ doubles its stock price over time to $20 per share, then your investment would be worth twice as much ($2,000).
The size of a company can be estimated in part by looking at its market capitalization. The value of a company’s outstanding shares of stock includes both those that are freely traded on the market and those that are held in restricted form by company insiders and executive management.
The market capitalization of a publicly traded company ebbs and flows in tandem with the changing share price. The number of shares issued and outstanding is subject to fluctuation.
Keep in mind that the number of outstanding shares rarely shifts, changing only when the company performs specific corporate actions like a secondary offering, the exercise of employee stock options (ESO), the issuance or redemption of other financial instruments, or the repurchase of its own shares.
Investors should keep an eye on corporate-level developments that may change the number of outstanding shares, but share price fluctuations are the primary driver of market capitalization fluctuations.
As an investor, it is crucial to know the value of a company, but it’s not always easy to do so quickly and accurately.
For publicly traded companies, estimating their value with market capitalization is a simple and efficient way to extrapolate what the market values them at.
When a company goes public and its shares begin trading on the exchange, the price of those shares is set by the market based on the supply and demand for those shares.
The price of its stock would rise if there was a high demand for it because of positive factors. The stock price could fall if investors are pessimistic about the company’s future prospects. This makes market cap a live, constantly updated estimate of a company’s worth.
The market cap of a company is not a perfect indicator of its value or worth, however.
In fact, some companies with low market caps can be more valuable than others with higher market caps.
The reason for this is simple: It is all about what investors think about the future prospects of each business. If investors believe that one company has better prospects than another, they will bid up its share price and push up its market capitalization.
Conversely, if investors do not see much potential in a given business, then they won’t pay much for its shares—and thus its market cap will be lower as well.
What are the types of market capitalization?
Some businesses may be considered mega-caps, while others may be considered micro-caps. The exact boundaries between the categories may change, but typically they are as follows:
Mega-cap companies have a market capitalization of over $200 billion. These are the most valuable companies listed on public stock exchanges, and they often serve as benchmarks for their respective industries. Only a select few businesses can fit into this category.
Large-cap companies have a market value of $10 billion to $200 billion. Blue chips often refer to both mega-cap and large-cap stocks because of their stability and security. However, since all businesses are vulnerable to market risks, there is no assurance that these companies will keep their stable valuations.
The mid-cap ranges from $2 billion to $10 billion in market capitalization. Compared to large and mega caps, these businesses experience greater swings in their stock prices. The vast majority of mid-caps are growth stocks. Some of the firms may already be market leaders, while others may be just starting out.
Small-cap companies have a market capitalization of $250 million to $2 billion. This group is dominated by startups with bright futures, but it also includes some well-established companies that may have seen their value decline for various reasons in recent years.
Companies in this category typically have shorter track records than their mid- to mega-cap counterparts, but they also offer a higher potential for capital appreciation.
Micro-cap companies, also known as penny stocks, have a market cap of around $50 million to $250 million. For instance, a company with a small valuation and low trading volume may be listed if it is developing a drug for an incurable disease or has only five employees working on AI-powered robotics technology.
While there is much to gain from the success of such businesses, there is also much to lose if they fail. Due diligence may be warranted for those considering investing in such companies.
Some stock indexes and investment funds will use this metric to classify companies into similar size categories.
After the micro-caps, the nano-caps are the next layer of high-risk, high-reward investment. Market capitalizations of nano-cap companies are less than $50 million.
Gain potential is highly variable for these high-risk businesses. These are often pink sheet traded stocks, or stocks that trade on over the counter bulletin boards (OTCBB).
A historical look reveals that large and mega-caps grow more slowly but with less risk than small and midcaps, whose growth potential is higher but comes with greater risk.
Changes in market capitalization frequently result in companies moving between the various classifications.
Mutual funds and exchange-traded funds (ETFs) are also examples of popular investments that fall into the same small-cap, mid-cap, and large-cap categories as companies. The terms denote the categories of stocks in which a given fund invests primarily.
Because of this, if you are looking to diversify your portfolio with companies of varying sizes, market capitalization can be a useful metric in determining which stocks to pursue.
Companies with a larger market cap contribute relatively more to an index like the S&P 500, which is comprised of mega-cap and large-cap stocks and is weighed by market cap. The Russell 2000 Index tracks the performance of small and mid-sized companies in the stock market.
The number of outstanding shares is more relevant than the stock price when assessing a company’s size, which is a common misconception among novice investors.
Consider Corporations A and B as an example. The stocks of both companies are valued at $50 per share, but while Company A has 5 million outstanding shares, Company B has 5 billion outstanding shares.
In this comparison, Company B has a market cap of $250 billion, making it an extremely large, large-cap, or mega-cap, company, while Company A has a market cap of $250 million, making it a small-cap company.
Why does market capitalization matter to investors?
Market capitalization is a measure of how valuable a company is, and it’s important for investors to understand because it allows them to compare companies based on their market caps.
For example, let’s say two companies in the same industry have the same number of shares outstanding (i.e., number of shares that have been issued by the company).
One has a share price of $100/share and one has a share price of $20/share. The higher-priced stock would have a larger market cap than the lower-priced stock because each share represents more value.
As such, investors can use market capitalization as an effective comparison tool when comparing similar companies within an industry or across exchanges (such as those listed on Nasdaq vs NYSE).
As another point to begin with, a company’s market capitalization can serve as a rough indicator of its current stage of development.
Is this company, for instance, just going public now? In that case, there may be room for expansion. Indeed, many businesses opt to go public in order to gain access to investor capital in order to grow.
The size of a company’s market capitalization can be used as a proxy for its longevity. Companies with a large market capitalization are typically more stable through market fluctuations than those with a medium or small market capitalization, and vice versa for small and mid-cap companies.
Companies with large amounts of market cap are usually large companies that have been around for a long time.
It is always important to note that market capitalization does not tell you anything about whether or not you should invest in a company—it only tells you how much money has been spent on those shares so far.
It’s an important factor when deciding which stocks you want to invest in because it indicates how much money there is available for growth or expansion, which will affect their future earnings potentials as well as their profits from existing operations over time.
As an investor, you also need to know that market capitalization is also used to compare companies within industries and against competitors.
For example, if you want to compare two stocks in the same industry (such as technology), then market cap is a good metric for comparison.
However, if you want to compare companies across different industries (for instance, Apple with Disney), then market cap is not an ideal metric because it does not take into account other factors such as revenue or profit margins.
One reason their longevity is that larger businesses can more easily absorb losses and recover from slow years because they have larger financial reserves.
However, in times of economic expansion, smaller companies may be better positioned for rapid expansion than their larger counterparts. That is why some investors narrow their search for dividend stocks by considering only those with a certain market capitalization.
Because small-cap companies are typically still in their growth stages, their stock prices reflect that. Their focus on expansion and growth may make them more susceptible to financial instability.
As a result, small-cap stocks tend to experience greater swings in price than those of larger corporations. Large-cap stocks typically grow more slowly than small- and mid-cap stocks and are more likely to pay dividends.
These broad strokes do not promise that any given large-cap or small-cap firm will survive or thrive in a given economic climate. However, market capitalization can be a useful indicator, especially when it comes to portfolio diversification.
The purpose of diversification is to reduce exposure to risk by distributing capital across multiple markets. You can spread your investment risk by buying shares of multiple companies or bonds and stocks.
Even within asset classes, diversification is possible. One way to diversify within a single asset class is to invest in both small- and large-cap stocks.
Market capitalization is just one of many factors to consider when making investment decisions. Other important metrics include the company’s financials, its management team and its competitors. The market cap is an important metric but it’s only one factor in your decision-making process.
What is a diluted market cap?
The total value of a security on the market is affected by the number of shares currently issued and outstanding. New tokens or coins are issued or minted frequently in the cryptocurrency industry, making this a common practice.
A different market cap formula can be used to estimate what the market cap could be if all authorized shares or tokens were issued and still worth the current trading price, despite the fact that new offerings theoretically dilute the value of existing coins, tokens, or shares.
The formula for calculating the diluted market cap is as follows: Diluted Market Cap = Current Share Price * Total Number of Shares Authorized
Diluted market cap is a tool used by analysts to forecast the future value of a security, token, or coin.
Therefore, businesses with large amounts of unsold securities are more likely to see price declines if investors want to maintain the same market capitalization regardless of the number of outstanding tokens.
What does market capitalization tell you about a company?
A larger market capitalization indicates a more prominent market position for the company.
While smaller businesses may have more room for expansion, larger corporations may benefit from lower financing costs, a more reliable revenue stream, and stronger brand recognition.
Although this holds true for all businesses, larger market cap firms tend to be safer than their smaller counterparts.
Having a sizable market cap comes with both benefits and costs. On the one hand, banks and buyers of corporate bonds may be more willing to provide favorable terms to larger companies.
Additionally, these firms may enjoy competitive advantages stemming from their size, such as economies of scale and name recognition.
However, it is possible that large businesses will see their growth rates slow as they reach a plateau due to a lack of viable expansion opportunities.
Instead of influencing it, market capitalization is determined by looking at the current stock price in conjunction with the total number of outstanding shares. A blue-chip stock’s higher market cap does not necessarily translate into higher stock prices; however, increased organizational efficiency and visibility in the market can boost performance.
It could be argued that analysts do use market cap to identify under- and overpriced stocks. When viewed through this lens, market capitalization can influence an investor’s decision to buy or sell a company’s stock.
It is the market, not the market capitalization of a company, that ultimately decides the price of a share of stock.
A company’s size can be gauged by its market capitalization. It’s a vital analytical instrument for making firm comparisons.
All other financial metrics must be interpreted in light of market capitalization, so it is common practice to use it as a starting point for analysis.
It is possible, for instance, that a company’s revenue was twice as high as that of its competitors. However, one could argue that the company is underperforming if its market cap is four times larger.
When keeping tabs on stocks or considering investments, market capitalization can be helpful. For publicly traded companies, estimating their value with market capitalization is a simple and efficient way to extrapolate what the market values them at.
Instead of looking at sales or total assets, this is the metric that investors use to gauge a company’s size. The market capitalization of a company is used in an acquisition to evaluate whether or not it is a good value.
What should you keep in mind when you look at market capitalization?
Inexperienced traders and investors, in particular, may incorrectly assume that a stock’s price reflects the true value, health, and stability of a company.
A higher stock price may be seen as a sign of a reliable company, while a lower one may be seen as a good opportunity to save money.
But the truth is that the value of a company cannot be gauged from its stock price alone. You need to take market capitalization into your calculations as well because it reflects the value as seen by the market as a whole.
If a company is worth billions, it can afford to risk losing hundreds of millions of dollars on a risky new business line without collapsing.
Smaller or mid-sized companies may not have the financial resources to weather the same kind of storm if a value investment they make fails.
Even if the venture is successful, the impact on large-cap companies’ bottom lines may be negligible.
Profits can increase dramatically, however, if the business is able to expand in tandem with its growing success. The opposite is true for mid-cap companies, whose valuations can be boosted significantly by the success of such ventures.
Keep in mind that since stock price is set by the market, market capitalization represents investors’ opinion of a company’s worth.
The sum of a company’s parts may not equal its market value. Expectations of future growth or the introduction of a product could contribute to some of this perceived value; however, if these expectations do not materialize, the share price of the company, and thus its market cap, is likely to adjust accordingly.
For this reason, it’s wise to evaluate potential investments using a wide range of metrics. You can use market capitalization as a tool, but it should not be the only one, when building a diversified portfolio.
A high stock price is not necessarily indicative of a successful or expanding business. It is fine for it to have a modest market cap.
Reports of a large company moving into a mid- or small-cap firm’s market space can be devastating to the value of the latter.
For instance, smaller companies operating in the niche space have been under intense pressure ever since Amazon entered the cloud hosting services market under the Amazon Web Services (AWS) umbrella.
Mega-cap and large-cap stocks are typically seen as safer bets with lower volatility than small-cap stocks. Despite the high potential returns for risk takers in mid and small cap stocks, these companies’ limited resources make them more vulnerable to competition, uncertainty, and business or economic downturn.
The values of market capitalization are also the starting point for many different market indexes.
The S&P 500, a popular equity index, tracks the performance of the 500 largest publicly traded companies in the United States and is weighted by market capitalization, while the FTSE 100 tracks the performance of the 100 largest publicly traded companies traded on the London Stock Exchange.
These indices not only reflect the state of the market as a whole but also serve as yardsticks against which the success of specific investment vehicles can be measured.
What does being undervalued mean?
Being undervalued is a good thing. It means that a stock is trading below its intrinsic value, or the actual worth of the company. While this can be seen as a sign of cheapness, it is important to note that being undervalued does not mean that you should automatically buy stocks with low market capitalization.
Instead, it is better to think about investing in undervalued companies as an opportunity for good value—and remember that these investments may come with greater risk than other types of assets like bonds.
What does being overvalued mean?
Being overvalued means that a stock’s price is higher than its intrinsic value. This can be good or bad, depending on your perspective.
If you are an investor who wants to sell soon and make a profit, then it’s great. If you are an investor who just purchased overvalued stock, then not so much.
Overpriced stocks are more likely to drop in price than undervalued ones because investors have already priced in all of the good news they expect from a company’s future earnings growth into their current share price. This makes the stock vulnerable to price corrections or even a sharp decline.
On the other hand, if you plan on holding onto your investment for years or decades, then being overvalued may not matter as much because long-term trends tend to take precedence over short-term fluctuations in stock prices.
These trends tend towards higher valuations as time passes by regardless of whether or not markets are experiencing corrections during those periods.
How do you know if a company is overvalued or undervalued?
The market capitalization of a company is calculated by multiplying its stock price by the number of shares outstanding. This can be a useful tool for investors to determine if a company’s stock is overvalued or undervalued, but it does not tell you everything you need to know about the company.
To make an educated decision about whether or not to invest in that particular stock, it is important to consider other factors as well.
A company’s or an asset’s value can be calculated through a process called “valuation,” which involves extensive research and analysis.
Numerous methods exist for calculating a valuation. When determining a company’s worth, analysts consider a number of factors, including management quality, capital structure, expected earnings growth, and asset market value.
For example: Earnings available to common shareholders multiplied by the number of shares of common stock outstanding equals the EPS formula.
Earnings per share (EPS) is a measure of a company’s profitability because investors place a higher value on a company whose stock has higher EPS.
For stock valuation, analysts also use the price-to-earnings (P/E) ratio, which is found by dividing the stock price by earnings per share. The price-to-earnings ratio (P/E ratio) establishes how pricey a stock is in relation to its earnings per share.
If a stock’s P/E ratio is 20, for instance, an analyst will look at similar companies in the same industry as well as the P/E ratio for the market as a whole.
A multiples-based valuation, or multiples approach valuation, is a method of determining a company’s worth based on a series of ratios, such as the price-to-earnings ratio.
Intrinsic value can also be determined by comparing other multiples, such as EV/EBITDA, to the multiples of similarly situated businesses and to historical multiples.
Essentially, price-to-earnings ratio (P/E) compares how much investors are willing to pay for each dollar earned by a company. It is expressed as “price” divided by “earnings per share”.
A high P/E ratio could mean that investors think this business will grow faster than others in its industry. However, it could also mean that they think these earnings may not last long so keep in mind to look at how much growth has been happening over time too.
The fair value of a security can be calculated by calculating the price at which a willing buyer would part with their money to purchase the security from a willing seller. The market price of a stock or bond is established when it is traded on an exchange between interested buyers and sellers.
However, the concept of intrinsic value refers to the value of a security independent of its market price and is based on future earnings or other company attributes.
This is where an estimate of value can be helpful. To ascertain whether a company or asset is fairly valued by the market, analysts perform valuations.
By focusing solely on fundamental factors, absolute valuation models seek to determine an investment’s “true” or “intrinsic” value.
When conducting a fundamental analysis, one need only consider a single company’s dividends, cash flow, and growth rate without regard to the performance of competing businesses.
The asset-based, residual-income, and dividend-discount models, as well as a few others, all fit into this category of valuation techniques.
In contrast, relative valuation models function by comparing the target company to other companies in the same industry. The price-earnings multiple and other ratios can be calculated and compared to the ratios of comparable companies using these techniques.
A company may be considered undervalued, for instance, if its P/E ratio is lower than that of a peer group. Many investors and analysts jump right into analysis by starting with the relative valuation model because it is typically much simpler and faster to calculate than the absolute valuation model.
It’s easy for novice investors to feel lost among the many stock valuation techniques when trying to make their first choice. There are simple approaches to valuation, and there are also more complex ones.
Unfortunately, there is no universally applicable strategy. Different stocks and industries have different characteristics that could call for different approaches to valuation.
The same asset or company can be valued in several different ways, and this can lead analysts to choose whichever method yields the highest return.
Market capitalization is an important metric for investors to consider but it’s only one piece of the puzzle. Market cap is simply the total number of shares outstanding multiplied by their price per share.
Because this figure represents all available shares in existence— including those held by insiders or institutions—you may want to look at other metrics as well when trying to determine whether a stock is worth buying.
These include earnings per share (EPS), price-to-earnings ratio (PE), price-to-book ratio (PB) and dividend yield.
The big question to ask yourself before making an investment is not how much something is worth but how much it’s going to be worth in the future.
A company with a low market cap can be just as profitable as one with a high market cap, so don’t get too fixated on one metric alone. Instead, look at other metrics like growth rate, profit margin, debt level, and cash flow.
As an investor, you need to determine what type of investor you are first: long-term or short-term. Then focus on the right metrics for your strategy.
Long-term investors look at market capitalization as only one of many factors when determining whether or not to invest in a company. The reason is because it does not tell them as much about a company’s future prospects as some other metrics do like earnings growth.
Instead, they consider things like valuation ratios (price/earnings ratio) and cash flow projections based on historical data from similar companies in similar industries over time periods.
Short term traders may use other indicators such as relative strength index or moving average convergence divergence alongside market cap.
Market capitalization will never show you the complete picture. When buying stocks, make sure you consider all possible variables so you can focus on the right metrics for your investing strategy.