Market capitalization is the total dollar value of a company’s outstanding shares of stock. Also referred to as market cap, it is calculated by multiplying the total number of a company’s outstanding shares by the current market price of a single share in the company.
For example, a company with 5 million shares that have a current market value of $100 each would have a market capitalization of 500 million. The market capitalization figure is commonly used by investors to determine the size of the company rather than using sales or total asset figures. Market capitalization is also used in acquisitions to help determine whether a takeover represents good value.
How market capitalization works
Market capitalization takes all available shares in the market into account. It excludes locked-in shares such as those held by company executives. The market capitalization figure is affected by the current market value of the shares. For example, if the current share price decreases so will the market cap, but if the share price increases then the market cap will increase too.
Warrants can also impact a company’s market capitalization as they increase the number of available shares. A warrant gives investors the right to buy a specified number of shares at a specific price in the future.
Two companies with wildly different share prices can actually have a very similar market capitalization, this is down to the number of shares available. For example, Coca-Cola Co has a current share price of $54.44 and a market cap of $235 billion, compare this with Netflix that has a share price of $589.35 and the market capitalization is not too different at $260.84 billion.
Stock prices alone can sometimes be misleading when comparing the performance of two or more companies, but as market cap ignores capital structure it can give investors a better understanding of the companies relative sizes.
It is also important to note that large companies tend to offer more stable investments, but as mature businesses their potential for growth is limited as they are likely to have grown as much as they are going to. Smaller companies however are less stable and riskier but have the room to grow exponentially, and could potentially deliver a greater return on investment.
Types of market capitalization
Market capitalization ranges are often categorized across companies of different sizes. See the table below for a breakdown of the categorization:
Mega Cap – more than $200 billion
Large Cap – $10 billion to $200 billion
Mid Cap – $2 billion to $10 billion
Small Cap – $300 million to $2 billion
Micro Cap – $50 million to $300 million
Micro and small cap stocks may include new companies that have a large potential for growth, but may also be vulnerable to competition or economic conditions.
Mid cap stocks are established businesses that still have room to grow and are less risky than small cap ones.
Large and mega cap stocks are stable businesses that may return constant dividend payments but have little room for growth.
Advantages of market capitalization
The advantages of market capitalization include:
Makes it easier to value a company
Using market capitalization can make it easier for investors to value a company or compare two or more companies to help inform their investment decisions.
Can highlight greater returns
Companies with a mega cap or a large cap can often generate larger returns in the form of strong dividends, market capitalization can help investors highlight these companies.
Aids portfolio diversification
Through gaining a better understanding of different companies values and relative size, investors can use market capitalization to diversify their portfolio by investing in a mix of micro, small and large cap companies.
Disadvantages of market capitalization
The disadvantages of market capitalization include:
Doesn’t factor in company debts
One of the biggest drawbacks of market capitalization is the fact that is does not factor in any debts that the company may have. Using market capitalization to value a company with high levels of debt can give an unrealistic view and value of the company and will not consider the cost involved in servicing the burden of debts.
Ignores stock splits and other factors
Another disadvantage of market capitalization is that it does not take into account returns such as stock splits, dividends or shares outstanding. Without factoring these into the equation the valuation of the company may not be accurate and could lead to bad investment decisions.