Market capitalization is theoretically the market value of the equity of a company or corporation. It represents the equity side of the total valuation of a company.
Market cap can be used as a useful tool in the total market valuation analysis. However, unlike the common notion, it does not represent the total market value of the company.
Companies can be typically categorized based on their market cap. It can be used as a good indicator of the financial health and performance of a company.
Let us discuss the concept of market capitalization with the help of a few real-world examples.
Market Capitalization – Definition
Market capitalization or Market Cap refers to the latest market value of total outstanding shares of a company in dollar terms.
By definition, it uses the current market value of the shares and the total outstanding shares figure. Unlike the equity valuation of a company, the market cap considers the current market prices of the shares.
The equity valuation considers the book value or par value of the outstanding shares. Thus, both methods represent the total book value and the total market value of the company in terms of equity respectively.
Also, analysts must recognize the fact that the market cap only represents the market value of the equity of a company. It does not include other valuations such as debt and assets owned by a company. In other words, it does not represent the full market value or takeover value of the company.
How to Calculate Market Capitalization?
Theoretically, there are only two components to calculate the market capitalization of a company. These are the number of outstanding shares of a company and the current market price of the shares.
The formula to calculate the market capitalization is given here.
Market Capitalization = Total Outstanding Shares × Current Market Price of a Share
The total outstanding shares figure can include:
- Shares held by retail investors
- Shares held by corporate and institutional investors
- Shares held by the management and employees
The second element is the current market share price of the company that changes frequently. It can be retrieved at the time of calculation from the publicly listed platform where the company has been listed.
Any changes in the total outstanding shares figure would change the market cap of the company. These changes can be through an issue of new shares with secondary shares issue, share repurchase programs, employee share compensation programs, management buyouts, and so on.
Understanding Market Capitalization
Market capitalization is one of the several ways to determine the size of a company. However, as noted earlier, it does not represent the total size of the company. Rather, it represents the market value of the company that relies on the equity valuation.
Experts argue that the share’s current market price represents the effects of assets owned, liabilities due, and debts possessed by a company. The proponents relate the current market share price to the efficient market hypothesis.
It can be argued that when the current share price of a company reflects these elements, its market capitalization would reflect the true value of the company. However, it is not the case in practice very often.
Several other factors such as intangible assets, goodwill, the impact of debt, market share, and growth prospects of the company contribute to the valuation analysis. Thus, market capitalization can be used as a starting figure in the valuation process rather than taking it as the absolute measure.
Another key point to remember is the changing value of the market cap. The changes due to the outstanding shares do not happen frequently. These events are planned and executed infrequently. However, due to share price changes, the market cap of a company changes frequently.
Working Examples
Suppose a company ABC has 2 million outstanding shares in issue currently. Its current market share price is $ 35. We can calculate the market capitalization of the company by multiplying the two figures simply.
Market Capitalization = Total Outstanding Shares × Current Market Price of a Share
Market Capitalization = 2,000,000 × $ 35 = $ 70,000,000
Let us consider a few real-world examples to calculate market capitalization.
1. Facebook
Total Outstanding Shares = 2,843,000 million (including Class A and Class B Common Stocks)
Current Share Price = $ 341.88
Market Capitalization = Total Outstanding Shares × current share price
Market Capitalization = $ 971.96 billion
2. Amazon
Total Outstanding Shares = 506.44 million
Current Share Price = $ 3,415.06
Market Capitalization = Total Outstanding Shares × current share price
Market Capitalization = $ 1729.52 billion
Impact of Share Price on the Market Capitalization
Continuing with our examples above, Amazon has a market of $ 1,729 billion that is almost double the Facebook market cap of $ 971 billion.
Amazon has only 506 million shares outstanding whereas Facebook has issued a staggering 2,843,000 million. It means Facebook has issued almost six times more shares than Amazon.
We can see the major difference comes from the current market share price and the outstanding shares. These are the two components to calculate the market cap of any company.
Amazon’s staggering market cap of $ 1,729 billion is largely due to its high market share price of $ 3,415.
It is also important to mention that the share prices of a company move largely due to the demand-supply rule. When demand for the shares of company increases, it pulls the share prices up and vice versa.
Also, large publicly listed companies can issue new shares to reduce the share price. It would affect the market cap as well. Similarly, a company can use its reserves to buy back shares from the market.
Although the total outstanding figure is the main item in the calculation, the market cap of the company is largely determined by the current market price of the share of the company.
Evaluating a Company by Using Market Capitalization
Market cap is one of the key metrics to understand the financial health of a company. It takes the current share price of the company analysis to the next level.
Companies are categorized based on their market capitalization figures. A large market cap company would indicate a strong financial position. However, these companies also have slower growth rates as compared to small or mid-cap companies.
Investors can use market capitalization as a starting point to evaluate their investment options. Market cap can offer a snapshot of the overall financial health of a company. However, it does not guarantee higher returns if the market cap of a company is higher as compared to another company.
Market cap is also used in the calculation of several other financial ratios. Thus, like any other financial ratio, the market cap figure should also be considered in the broader context.
Categorizing Companies Based on Market Capitalization
Market capitalization is the total dollar value of the company in terms of its share price and outstanding shares. With constantly changing market share prices, the market caps of the companies change as well.
Analysts can use any type of categorization based on the size of the market capitalization of listed companies. We’ll discuss a few commonly used terminologies associated with market caps.
Mega-Cap
The Mega-cap is a recent trending term that has emerged due to the extraordinary market capitalization of a few blue-chip companies. These companies have a market cap of more than $ 200 billion.
Examples include Amazon, Facebook, Microsoft, and others.
Large-Cap
Companies with a total market cap of $ 10 billion to $ 200 billion are categorized as large-cap companies. These companies also have highly stable financials generally.
Examples of large-cap entities include IBM, GE, etc.
Mid-Cap
Companies with a market cap of $ 2 billion to $ 10 billion are termed as mid-cap. These companies are usually fast-growth companies in their relative industries.
Mid-cap companies are considered volatile as compared to large or mega-cap companies. However, they possess strong financial performance indicators due to high growth.
Small-Cap
Small-cap companies come with a market capitalization in the range of $ 300 million to $ 2 billion. These are young and aspiring companies generally. These companies also come with growth prospects. However, these are more volatile than mid or large-cap companies.
Micro-Cap
Micro-cap companies have a market capitalization of less than $ 300 million. These are considered penny stocks.
More often these companies include startups and companies in early growth stages. These companies are highly volatile and risky.
Market Capitalization Vs Shares Outstanding
Some people may confuse the share outstanding figure with the total market cap of a company. In practice, the shares outstanding are only one component of the calculation.
The number of share outstanding figures can be retrieved from the balance sheet or the statement of owner’s equity. It includes the common stocks for all classes such as class A, Class B, or Class C category shares in issue.
A key point to remember here is that a company may have a large number of common stocks approved. Companies do not necessarily issue all of the approved stocks at once.
