Key Takeaways
When you're investing, you want to know a company's value before you commit your hard-earned money. Understanding market capitalization, or market cap, can help. Market cap provides a quick snapshot of a company's size, which is crucial because it often influences the risk and return profile of an investment.
Understanding market capitalization helps you make informed decisions about where to invest your money, balancing risk and reward in your portfolio. Let's take a closer look.
In this article, we will discuss:
What is market cap & how is it calculated?
Market capitalization refers to the total value of a company's outstanding
How market cap is calculated
The market capitalization formula is:
Market cap = Total number of outstanding shares x share price
For example, if a company has 10 million shares outstanding and each share is currently priced at $50, the market cap would be calculated as follows:
Market cap = 10,000,000 x 50 = $500,000,000
This means the company is valued at $500 million on the stock market.
Why market cap is important
Market cap is important to evaluate many fundamental aspects of a stock:
- Relative size. Market cap indicates a company's size compared to others in the same industry.
- Growth potential. Larger companies might have more resources for expansion and for paying dividends, but smaller companies can offer higher growth potential.
- Risk assessment. Smaller companies might be more volatile, while larger companies are generally considered less risky.
- Valuation. Market cap can be used to calculate price-to-earnings (P/E) ratios and other valuation metrics.
- Diversification. A
diversified portfolio can include stocks of varying market caps to balance risk and reward.
Market cap categorizes companies into different size groups:
- Large cap (more than $10 billion). Typically established,
stable companies with lower risk and steady growth. - Mid cap ($2 billion to $10 billion). Companies with higher growth potential than large caps but with moderate risk.
-
Small cap (less than $2 billion). Smaller companies with high growth potential but also higher risk.
Investors use market cap to compare companies and to diversify their portfolios across different-size companies to manage risk and target different growth opportunities.
What affects market cap?
A company's market cap can be affected by many factors:
- Stock price fluctuation. Because market capitalization is calculated by multiplying the number of outstanding shares by the current stock price, change in a company's stock price directly affects its market capitalization. If the stock price increases, the market cap also increases. If the price decreases, the market cap decreases.
- Earnings calls. Strong earnings reports can boost investor confidence, leading to increased demand for the stock and a higher market cap. Conversely, disappointing earnings can lower the market cap.
- Recent business developments. Positive developments such as new product launches, acquisitions or partnerships can increase market cap, while negative events like lawsuits, product recalls or management changes can have the opposite effect.
- Stock splits. A stock split—when a company divides all of its existing shares into multiple shares without changing the total value—can make shares more affordable for a broader range of investors, potentially increasing demand and boosting the market cap.
- Buyback programs. When a company repurchases its own shares, it reduces the number of shares available on the market. This can increase demand for the remaining shares, driving up the price and market cap.
- Industry trends. The performance of the industry in which a company operates significantly can impact its market cap. Positive industry trends can boost investor sentiment and drive up stock prices.
- Economic indicators. Macroeconomic factors such as interest rates, inflation and gross domestic product (GDP) growth can influence market sentiment and affect stock prices. (GDP is the measure of all goods and services produced by a country during a particular period.)
- Investor sentiment. Overall market sentiment, including investor confidence and risk appetite, can affect stock prices and market caps.
- News and events. Company-specific news, industry developments and global events can cause stock prices to fluctuate, affecting market cap.
- Supply and demand. The balance between buyers and sellers in the market can drive stock prices and market caps.
What's the difference between market cap & a company's value?
Since market cap is a measure of a company's total number of outstanding shares multiplied by its share price, it's a quick way to get a sense of a company's size and relative importance in the market.
Determining a company's value is more complex and accounts for market cap as well as several other factors. It considers the company's future earnings potential, growth prospects, competitive advantage and overall financial health. Intangible factors such as goodwill, patents owned or reputation also can affect a company's value.
While market cap is a useful metric, it doesn't capture the full picture of a company's true worth. Thus, in essence, market cap is a snapshot of a company's value based on current market sentiment while the company's true value is determined by a more comprehensive analysis of its business fundamentals and potential.
Why market cap matters to you
Understanding a company's market capitalization—that company's stock price multiplied by the total number of shares outstanding—is more than just knowing its size. It's a key to making smarter investment decisions. Market cap provides insight into a company's stability, growth potential and risk level, helping you align your investment choices with your financial goals.
Whether you're looking to build a diversified portfolio or simply gauge the market's perception of a company, market capitalization serves as a fundamental tool.
For assistance in considering market cap in determining your overall financial strategy, contact a
