Some stock market terminology can leave you totally perplexed, but at the same time, adds value to your understanding of the markets. One such term is market capitalization, or market cap, for short.
How Market Capitalization Works
Market cap is a metric that values a company by taking into account the number of outstanding shares and the current market price of its shares. Market cap is the product of the number of outstanding shares and the market price per share of the company.
- Outstanding shares refer to the shares held by all shareholders, including retail and institutional investors, and company insiders and executives, who hold restricted shares in the company. In other words, outstanding shares refer to shares authorized by a corporate charter and issued to an investor.
- Restricted shares are transferable if they are meeting certain conditions.
- There is another measure called free-float market cap, which takes into account only free float or freely tradable shares or shares available for trading by the general public while calculating market cap, leaving out stocks held by insiders, promoters, government, etc.
How to Calculate Market Capitalization
Shares of social media platform Twitter Inc. were on fire in 2018, with a host of factors that have catalyzed the upward momentum.
The number of outstanding Twitter shares on March 31, 2018 was 752,037. To calculate the market cap of Twitter as of June 13, use the closing price of the day, $44.07. To calculate, the market cap of Twitter is 752,037 * $44.07 = $33.14 billion (as of June 13, 2018).
Factors that Affect Market Cap
Market cap is a product of two items or the number of outstanding shares and market price, so any factor that impacts these can affect market cap. Share price is dictated by a host of factors:
- Demand and supply
- Fundamental strength of a company
- Competitor performance
- Any market-sensitive or company-specific news
- Factors extraneous to the company such as macroeconomics, geopolitics, etc.
The number of outstanding shares depends on:
- Issue of new shares
- Buyback of shares
As the exercise of warrants on shares are done at a price below the market price, it could affect the market value of a company. However, stock splits or dividends rarely impact market cap, as with a split/dividend the number of outstanding shares increase. However, the effect is nullified by a reduction in the market price of the share.
Classifying Large and Small Market Caps
Based on market cap, companies can be classified into nanocaps, microcaps, small-caps, mid-caps, large-caps and mega-caps. The criteria for each category:
- Nanocap: Stocks with a market cap of less than $50 million. They are usually penny stocks and are chased by traders, who are ready to take an enormous risk in a bid to pocket excessive profits. They normally trade in the over-the-counter bulletin board or pink sheets. An example of a nanocap is Aurora Solar Technologies, Inc.
- Microcaps: Stocks with a market cap between $50 million and $300 million, Citi Trends (NASDAQ: CTRN), with a market cap of $160 million, is a microcap trading on the Nasdaq.
- Small-caps: Stocks with market cap between $300 million and $2 billion; Altice USA, Inc. (NYSE: ATUS) is a small-cap stock, with a market cap of around $1.10 billion.
- Mid-caps: Stocks with market cap between $2 billion and $10 billion; Lear Corp (NYSE: Lear) is a has a market cap of around $6 billion.
- Large-caps: Stocks with market cap between $10 billion and $300 billion; Apple supplier Skyworks Solutions, Inc. (NASDAQ: SWKS), with a market cap around $15.24 billion is a large-cap.
- Mega-caps: Stocks with market cap over $300 billion; Microsoft Corporation (NASDAQ: MSFT) is an example of a mega-cap.
Market Cap: Equity Valuation and Enterprise Value
Market cap is one way of valuing a company; equity valuation is another way and gives the actual net worth of a company or the difference between assets and liabilities. It otherwise denotes the amount investors in the company will be left with when it is sold or liquidated at fair value.
Unlike market cap, which fluctuates wildly, equity valuation is relatively stable. Usually, market cap is higher than equity valuation, as the stock price discounts the future earnings potential of a company. Both metrics are used in calculating a ratio called price to book value (P/B), which is market cap divided by equity value.
If the P/B ratio is greater than one, it suggests that the company is overvalued by the market and vice versa. Meanwhile, enterprise value (EV) is: market cap + market value of preferred stock + minority interest - cash and investments.
Alternatively, one can calculate the net present value of all future cash flow using the discounted cash flow model to calculate EV.
Pros and Cons of Using Market Capitalization
Market cap comes with many advantages but it also comes with some disadvantages. Here are the pros and cons you can expect with market capitalization.
Advantages
- It is considered the easiest and most widely-used methods of valuing a company.
- Can zero in on relatively stable and safer companies, as large/mega-caps are perceived to generate safe returns even in times of a market downturn.
- Can understand the size of one company, relative to another.
- Used for weighting shares that constitute an index. A stock with a higher market cap gets a higher weighting in an index.
- Can also be used to build a well-balanced portfolio.
Disadvantages
- This measure does not take into account the debt load of a company. Therefore, a potential buyer, who values the company using market cap, might overlook the cost involved in servicing the debt burden.
- It also does not consider returns such as dividends, stock splits, etc.
Stock Price Effects Your Growth Rate
Market cap is a metric too hard for a potential buyer, promoter or an investor to ignore. However, it is always better to use this information with other valuation methodologies to know the overall worth of a company.
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Frequently Asked Questions
What is a good market cap for a stock?
When determining what is a good market cap for a stock, investors may look at the company’s industry or sector. Companies in different industries and sectors typically have different market caps. For example, large technology companies often have higher market capitalizations than small healthcare companies.
Is it better to have a high or low market capitalization?
The answer to this question depends on your individual goals and objectives. Generally speaking, a higher market capitalization generally indicates a company’s size or value in the marketplace. A high market capitalization usually reflects investor confidence in the company’s ability to generate future profits and growth, while a low market capitalization may indicate potential risk due to factors such as limited liquidity, lack of brand recognition, or limited financial resources.
What is market capitalization in simple words?
Market capitalization (or “market cap”) is a measure of the total value of a publicly traded company. It is calculated by multiplying the current market price of a company’s stock by its total outstanding shares.
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