What Is Market Capitalization?

Fundamentals · Jul 6, 2019

Market capitalization refers to the valuation of a certain company derived from the market value of its shares. It’s a simple, yet important metric in financial analysis that many investors look at regularly.

Market capitalization in finance is often shortened to market cap.

Illustration

In this article, we’ll explain the meaning of market capitalization, show how it can be calculated, and explain the key differences between market cap and book value of a company.

What Is Market Capitalization?

Market capitalization refers to the current value of a publicly-traded company’s outstanding shares.

Company’s market cap isn’t a stable value, it can change by a lot within a short period of time as the stock price fluctuates. The degree of those changes is called volatility.

The majority of services that provide market data for stocks (like Google Finance) track Mkt cap as well.

How to Calculate Market Value?

To calculate the market value of a particular company use this simple formula:

$$ MV = {N}\times{PPS} $$

Where:

  • MV: Market Value
  • N: Total Number of Publicly Traded (outstanding) Shares
  • PPS: Price Per Share

Therefore, if a company has 1,000,000 outstanding shares and they are traded at $10 each, the market cap of the company would be 10 million dollars (1,000,000 * $10 = $10,000,000). The current stock price of a company can be found easily, however, the number of shares outstanding might occasionally require a little bit of digging.

Market Cap Types

There is no legal or official way to distinguish companies by their market cap, but investors like to create groups, types, and categories to rank stocks or corporations according to their market cap. Here are 6 common types of these groups:

  • Mega Cap: above $300 billion
  • Large Cap: $10 - $300 billion
  • Mid Cap: $2 - $10 billion
  • Small Cap: $300 million - $2 billion
  • Micro Cap: $50 - $300 million
  • Nano Cap: below 50 million

Companies with nano and micro capitalizations are rare as the IPO process requires quite a lot of money, but without it, the company can’t be publicly listed in the first place.

Difference Between Market Cap and Market Value

Market capitalization is often confused with market value (even on major and serious websites). They sound similar, they both represent the current value of the company, however, these are two different things. As mentioned earlier, market cap shows the value of the company’s outstanding shares. Market value is a more complex measure of the company that considers a number of other metrics, such as price to earnings ratio, return on assets, etc.

Investopedia has a short article on how these two things are different.

Market cap of company X might be $100 million, which is based on the number of outstanding shares and the current stock price. However, what does this number tell us? It only says, in theory, how much would it cost to buy all the company’s outstanding shares, which might not even guarantee the full control of the company. Plus, it says nothing about the company’s real income, debts or other variables. Market cap only tells an investor how market values a portion of its shares that are outstanding.

True market value (open market value, fair value or fair market value) of a company is a broader estimation of company’s worth. It’s the total estimation of the company’s value, based not only on the value of its outstanding shares but also on other factors. Those factors may vary, and there is no clear and universal way to calculate market value.

In our previous example with company X that has market cap of $100 million, imagine that this company generates almost 0 net income at the moment and has a lot of debts (liabilities). A situation like this isn’t as rare as someone might expect. Does the total and fair market value of this company really equal to $100 million? Or is it just how the market values it at the moment based on some kind of hysteria or something? If someone were to buy the whole company from the market, would he or she assume that the market participants value this company correctly? It’s unlikely. More likely that this individual would hire an independent third party firm that will analyze not also market cap, but a few other variables.

Another similar economic value measure that takes into account additional metrics is called “enterprise value(EV) (or total enterprise value (TEV), firm value (FV)). It’s often used in the financial valuation process and there is a clear formula for its calculation, however, not all the required data can be easily obtained to calculate the enterprise value as some of it isn’t public.

Neither market cap nor market value shouldn’t be confused with the book value of a company.

Book Value vs. Market Cap

The book value is an accounting term that shows the value of a company from a different angle:

$$ BV = TA - TL $$

Where:

Book Value can be found in the balance sheet section of the company’s annual report.

If you are familiar with accounting you already know that the formula above also measures the company’s equity, or net worth of an individual. Book value is basically the same thing as equity.

➤ Read also: What is Equity in Financial Accounting?

So, how are book value and market cap different?

In short, the book value is recorded in the balance sheet of a company for a particular date of the report, for instance at the end of the year. The book value of all the company’s assets is readjusted (depreciated, etc.) based on a particular method this company uses, this is true for company’s investments as well. So, at any particular moment book value of the company has a lag from the real current market value of its assets, investments, and shares, or not even a lag, but the method of recording value could be different.

In summary, the key difference between book value and market cap is the frequency of fluctuations.

Usually, the book value of a big public corporation is smaller than its current market capitalization, sometimes this difference is huge and it’s a concerning sign. This means that the company is probably overpriced on the market and its current valuation doesn’t reflect its real value, so its stock price might go down at some point in the future.

Why is Market Cap Important?

How to use market capitalization to evaluate a stock and why it’s an important metric?

First of all, market cap is an essential element of various indicators:

  • Price to earnings ratio
  • Price to free cash flow ratio
  • Price to book value
  • Enterprise value to EBITDA

Secondly, some investors prefer to classify companies by their market cap (i.e. small, medium, large), and apply different trading and investing strategies to the company based on it.

Companies with large market cap are usually associated with mature and respectful corporations that often pay dividends, while small market cap companies often rely on the value growth of their stock and they are seen as more risky.

Lastly, comparing market capitalization with its book value can reveal the real financial situation within the company and help to determine whether its stock is underpriced or overpriced.

Analytics   Economics   Trading   Investing   Finance   Portfolio   Market

This page doesn't show ads and the reasons are simple:

  • Most people don't want to see ads (what a surprise)
  • Ads can track you and violate your privacy
  • Ads is the main reason why many websites are so slow

If you find this content valuable or you want to see more content like this, you can leave a tip with bitcoin:

3LW2Q71yaeaKM4ZxVdeMkLViRGp7HEiJDS
bitcoin tips QR