Table of Contents
What is market capitalization?
Pegging companies by market cap
How market cap can fit into an investment strategy
Market cap vs. other valuation metrics
The bottom line
Sep 9, 2022
7 min read
It’s used for comparing and ranking companies by size, and for benchmarking the stock returns of a company against an index of comparable companies based on market cap.
“Market cap” is a buzzword that generates headlines when a company reaches a milestone, such as Apple topped $1 trillion in market value, a first among U.S. companies.
Some might view market cap as equivalent to a company’s true value, but they would be wrong. Market cap, which is calculated off a company’s stock price, typically understates a company’s total value because it only accounts for its equity capital and not other sources of capital, such as debt used to finance operations or expansion. The company’s intrinsic value is actually its going-concern value, or the premium an acquirer would pay to have full control of the company’s business and future sales and profits.
Still, market cap is a handy reference. It allows investors to easily compare and rank companies by market cap size, and to gauge the performance of a stock or portfolio against an index of companies with a comparable range of market caps—a process called benchmarking.
Market cap is short for market capitalization, which is simply the total of a company's common shares outstanding multiplied by the current stock price. It changes each day because the stock price, which is driven by supply and demand for the shares, changes everyday.
Calculating a company’s market cap looks like this:
ABC Inc. has 100 million shares outstanding, and it currently trades at $50 a share. So:
100,000,000 X $50 = $5 billion market cap
The total number of shares outstanding used in the calculation should be fully diluted, meaning it includes shares from the exercise of stock options, warrants or debt convertible into shares. It should not include restricted shares, or shares held by company insiders or governments and not available for trading. This amount excluding restricted shares is called the float, or free float. Indexes such as the Standard & Poor’s 500 use the free float in calculating market caps of the companies included in the indexes.
Companies fall into different market-cap size categories: large, mid or small cap. Those in the large-cap category are considered more stable, balancing lower potential returns with lower price volatility. Mid-cap and small-cap stocks have progressively higher risk and return tradeoffs.
Over time, a rising stock price can change the company’s characterization by market cap. In the 1990s, Apple was a 50-cent stock, and Amazon traded for less than $1 a share. Market cap also periodically changes with the number of shares outstanding, which happens infrequently.
As stock market values have climbed in the past several decades, the market-cap ranges have shifted upwards. A company in the early 1980s was considered large-cap if its market cap was a few billion dollars; by contrast, Apple’s market cap approached $3 trillion in late 2021 and Microsoft’s surpassed $2.5 trillion.
The broad categories or classifications for companies based on the size of their market caps are:
: The generally accepted range for a company to be considered large cap was $10 billion or higher. It was adjusted to $13.1 billion or higher in 2021 by Standard & Poor’s Corp., creator of the S&P 500 and other popular indexes. Apple, Microsoft, and other companies are sometimes referred to as mega-caps–$200 billion or higher–because their growth has far eclipsed the old large-cap range.
: Historically $3 billion to $10 billion, it was adjusted up to $3.6 billion to $13.1 billion in 2021. Mid-cap companies are also established in their industries, but investors expect them to grow faster than large-caps. Faster growth may be accompanied by bigger swings in stock price along the way. Gap Inc. and Jetblue Airways are mid-cap companies. Some once-prominent companies that are now ranked as mid-cap include Alcoa Corp. and Goodyear Tire & Rubber.
: Previously $3 billion or less, now $3.6 billion or less. Small-cap companies are more likely to be young companies, in newer industries, still in the development stage or seeking markets for their products and services. They may have a limited record of sales or earnings, and are more vulnerable to swings in the economy, making their stock prices more volatile. Small-cap companies include Boston Beer Co., maker of Sam Adams and other beverage brands, and Dynavax Technologies, a developer of vaccines for hepatitis. Those with market caps of $850 million or less are known as micro caps. Many of these are startups that don’t yet have a product, revenue or earnings, and have very low stock prices. They are often referred to as penny stocks or pink-sheet stocks, which are thinly traded and have much greater price volatility.
Large-cap companies tend to attract more money as index investing becomes popular (large-cap indexes include the S&P 500 and Russell 1000). Large-cap companies are well established, with name and brand recognition for their products and services. They may better handle setbacks like an earnings slump or a new business venture that fails, because of their size and resources. They can benefit from economies of scale, with more cost-efficient production and distribution. And they may borrow more easily from banks or in bond markets, at better rates due to their established track record.
On the other hand, because they are older, large-cap companies may be past their prime and start to experience slower growth. While they may better absorb an earnings disappointment or failed venture, large-caps might not enjoy a notable boost in share prices from strong earnings or a successful venture, as a smaller company might.
Investors might weigh different market-cap categories by their risk and reward considerations: how much long-term growth do they want, and how much risk (price volatility) are they willing to tolerate?
Here are three hypothetical risk/reward scenarios for an investor over the span of five years:
A hypothetical large-cap portfolio might gain 10% annually with very little volatility, or 61% compounded for the five-year period.
A hypothetical mid-cap portfolio might return 15% a year for three years, a 10% loss in the fourth year, and a 25% gain in the fifth year, or 71% compounded.
A hypothetical small-cap portfolio might generate these returns: 25% gain each for the first and second years, a 10% loss for third year, 50% gain in the fourth year and a 10% loss in the fifth year, or 90% compounded.
The mid-cap and small-cap portfolios have higher compounded five-year returns, but with some losing years. The challenge for investors is deciding whether they can tolerate periods of losses, in the quest for greater long-term gains.
If you're curious about how compounding could potentially affect your investment returns over a period of time, check out Titan's Compound Interest Calculator.
There are a few other ways to value a company, depending on who’s doing the evaluating and for what purpose.
This metric is usually larger than market cap because it adds the value of company debt and preferred shares as other sources of capital, and subtracts cash and cash equivalents from its valuation. Enterprise value is typically used as a basis for negotiating prices of mergers and acquisitions.
Example: Company A has $25 billion market cap, $5 billion of bonds, $1 billion preferred shares, and $2 billion in cash/cash equivalents.
Enterprise value: $25 billion + $5 billion + $1 billion - $2 billion = $29 billion
Also higher than market cap, this is used internally by companies for planning and business decisions. Equity value differs from enterprise value by including a valuation of any non-operating assets.
Market cap is an easily calculated value of the total amount of shares outstanding of a company multiplied by the current stock price. It’s used for comparing and ranking companies by size, and for benchmarking the stock returns of a company against an index of comparable companies based on market cap. It’s important to understand the different market-cap categories because they may perform differently and thus can be used to diversify a portfolio.
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