Market capitalization: definition, formula, example
- Market capitalization (market-cap) is the total value of all shares of a company.
- Stocks are often categorized by the size of their market capitalization: large cap, mid cap, small cap or micro cap.
- An indicator of financial strength, market capitalization indicates how risky a stock is and the types of returns it could offer.
A big part of stock investing is determining the value of a company. If you can measure a company’s value, you’ll be in a better position to know if you want to commit your hard-earned capital to its stock.
One of the most common ways to value public companies is by market capitalization, or “market capitalization” for short.
What is market capitalization?
Market capitalization is the total value of a company’s outstanding shares. Essentially, that’s what it would cost you if you bought all of its outstanding shares at the current share price. It is a way of assessing the value that investors place on the company. Expressed in dollars (or whatever the local currency), it is made up of two factors: the number of outstanding shares of a company and the price of each share.
What makes market capitalization change?
Since it directly depends on a company’s share price, market capitalization changes every day. As the price of a stock increases, the market capitalization also increases, and vice versa.
Changes in the number of shares outstanding also influence market capitalization. Companies sometimes issue additional shares to raise capital or buy back shares. Assuming a constant share price, issuing shares would increase market capitalization and buying them back would decrease it.
Market Cap Categories and Investment Strategies
You will often hear companies ranked by their market capitalization. Based on dollar size, these classifications can also help investors choose the right stocks based on their investment goals and risk tolerance.
The most common market capitalization categories for stocks include:
Although there is no official or legal designation, there are generally agreed upon limits for each market capitalization category.
Micro-cap and nano-cap valuation
Micro caps are typically companies with a market capitalization between $50 million and $300 million. Nano-caps are those with a market capitalization of less than $50 million.
These are often very risky investments with a lot of volatility. Most penny stocks fall into the nano or micro categories.
Small Cap Valuation
Small cap companies are risky, but with a market capitalization between $300 million and $2 billion, they can offer opportunities for major appreciation. In fact, these companies are often the darlings of growth-oriented investors. Getting into the bottom tier of a successful small cap company can be very lucrative – if you guessed right. But it may take time to pay off, and unlike large or mid caps, it probably won’t pay much in terms of dividends or other returns in the meantime.
Small cap companies include Neophotonics, Unisys and Purple Innovation.
Mid-caps have a market capitalization between $2 billion and $10 billion. These are usually large, well-established companies. Some may be household names, such as American Eagle Outfitters, Lending Tree and TripAdvisor. Others may be less well known, but are respected and rapidly advancing in their field, such as Diamondback Energy.
As their name suggests, midcaps occupy a middle ground for investors. They may be riskier than large caps, but still relatively safe (certainly more so than small caps, from which they are often derived). Their stocks may be more volatile than those of large caps, but they may also have greater potential for appreciation, as many of these companies are still actively growing.
Large Cap Valuation
Large caps have a market capitalization of over $10 billion. These are very large companies, usually ones with long histories and household names like Visa, Johnson & Johnson, and Walmart.
They are generally less risky investments, given that they are backed by years of stable earnings and stock price performance. However, as mature companies, they usually don’t grow very quickly.
For investors, this means large-cap stocks can provide steady, but not massive, returns. Most blue chip stocks are large cap stocks.
At the very top of the large-cap spectrum, companies such as Apple, Amazon and Micro sft make up a small group commonly referred to as mega-caps. These are companies with a market capitalization of more than $200 billion.
Why is market capitalization important?
Market capitalization is an important concept because it allows investors to understand the size of a company and its value in the market. Since companies of different market capitalization sizes vary in terms of growth potential, income payout and risk, allocating your investments among them is a way to balance your portfolio between appreciation and income, between conservative and aggressive.
Often, investors focus on a particular market capitalization segment. Some may choose to stick with stable large cap stocks, especially if they want to preserve capital or earn income from their investments. Others may be attracted to the more volatile and exciting small cap stocks, especially if they have a long time horizon to weather the volatility or if they like aggressive growth stocks.
Crossing industries and industry sectors, each market capitalization group encompasses a wide variety of companies and stocks. Still, analysts note common trends and patterns among stocks of similar market capitalizations.
For example, Robert R. Johnson, professor of finance at Creighton University, notes that small caps can be more volatile than mid and large caps, but they tend to perform better. Large cap stocks provided average returns of around 10% per year from the turn of the 20th century to the start of the 21st century, compared to around 12% for small caps, he says.
That doesn’t look like much in percentage terms. However, “over many years, this difference is enormous: a dollar invested in large caps at the end of 1925, with dividends reinvested, would have reached $9,243.90. That same dollar invested in small caps would have reached 39 $380.90.” Johnson notes.
“Ultimately, small-cap stocks offer higher returns, on average, but that comes at the cost of higher risk.”
Market Cap vs Market Value
You will sometimes hear “market capitalization” used interchangeably with “market value”. But they don’t mean the same thing. While market capitalization is a single number and easy to calculate, market value is a more complex characteristic that we try to estimate in several ways.
As Ryan Maxwell, COO at FirstRate Data, notes, “market value” is an umbrella term that refers to the value of an investment (like a company’s stock) as determined by a market (usually the market scholarship holder). Reflecting investor sentiment, it can take into account company assets, fundamentals and other factors.
For example, Maxwell says, a company’s enterprise value is another specific measure of a company’s market value, which takes into account its debt as well as its stock.
Along with market capitalization and company valuation, investors often use ratios such as price-to-earnings ratio, price-to-sales ratios, and return on equity to compare values between companies.
“Everyone struggles to measure the true market value of a company,” says Asher Rogovy, chief investment officer at Magnifina. “Anyone who understands true value can profit from trading mispriced stocks. Market capitalization represents how investors, on average, estimate true market value. It’s an indicator of market value and a great starting point for analysis.
The bottom line
Market capitalization is a way to measure the value of a company. Essentially the collective price of all of a company’s outstanding shares, market capitalization tells us how much investors value a company’s stock. And that tells us, indirectly, what we can expect from the company in terms of performance.
Companies with lower market caps can be riskier, but can pay off big. Companies with larger market caps will likely preserve your funds, but may not offer massive gains.
If you are a more conservative investor, you can look to large caps. And if you’re looking for more than one bet, small caps might be for you. If you want balance in your portfolio – appreciation plus income – mid caps may be the way to go.