Market capitalization, commonly referred to as market cap, is an important financial metric used to determine the size and value of a publicly traded company.

Market Cap refers to the total market value of a company’s outstanding equity shares.  Essentially, it is the total equity market value of a publicly traded company and is calculated by multiplying the number of shares outstanding by the current share price. For example, if a company has 10 million shares outstanding and its share price is $50, the market capitalization is $500 million ($50 x 10 million shares). It represents the total value of a company’s shares held by shareholders.

The market cap figure gives investors a quick snapshot of the size and value of a company. It allows you to see how much the entire company is worth if all the shares were to be purchased. The larger the market cap, the bigger the company. Market capitalization is also sometimes referred to as equity market value or market value.

Article Contents

• Market Cap Formula
• Importance of Market Capitalization
• Classifications: Large Cap, Mid Cap, Small Cap
• Market Cap in Investment Analysis
• Common Misconceptions in Calculating Market Cap
• Market Cap and Investment Styles
• Limitations of Market Cap as a Sole Investment Metric
• Real-World Examples of Using Market Cap

Market Cap Formula

The formula to calculate market capitalization is simple:

Market Capitalization = Number of Outstanding* Shares x Current Share Price

Where:

*outstanding shares = issued shares less shares bought back by the company and held in treasury

For example, if a company has 5 million shares outstanding and its share price is $25, the market cap would be:

Market Cap = 5,000,000 shares x $25 per share

Market Cap = $125,000,000

So this company has a market capitalization of $125 million. The market cap changes daily as the underlying stock price moves up and down.

Importance of Market Capitalization

Market capitalization is an important metric in fundamental analysis and financial modelling for a few reasons:

1. Size – The market cap gives investors a sense of the size of the company and the total market value of its shares. This allows comparisons between companies as larger firms tend to have more resources.
2. Liquidity – Companies with large market caps tend to have higher liquidity in the market, meaning shares can be bought and sold easily. Mid and small-cap stocks tend to be less liquid, and potentially more volatile as a result (movements in price can be more ‘jumpy’)
3. Risk – Generally the larger the market cap, the lower the risk of the shares. Larger firms tend to be more diversified and stable. Small caps carry more business risk and liquidity risk, potentially.
4. Index Weighting – Most major stock market indices are Market cap-weighted. i.e. market cap determines the weighting and representation of companies in market indexes like the S&P 500. Larger companies account for a greater portion of index funds.
5. Valuation – Comparing a company’s market cap to financial metrics helps determine if shares are undervalued or overvalued. This ratio analysis includes price/earnings, price/sales, enterprise value* /EBITDA, and other multiples.

*in simplified terms, Enterprise Value = Mkt Cap + Net Debt

Classifications: Large Cap, Mid Cap, Small Cap

Companies, and stock market indices, and thus indexed investment funds, are often grouped into market capitalization brackets. The cut-offs for each category vary from market to market. For example, compare the US to the UK:

• Large Cap – In the UK, the large-cap index is the FTSE100 – the biggest 100 companies, by market cap, traded on the London Stock Exchange. At the time of writing this (early 2024) Shell plc is the largest UK company with a Mkt Cap of around £160bn. At the bottom of the large-cap index is the Games Workshop Group, with a Mkt Cap of just over £3bn.
  • In the US, Apple has a market cap of around $3trn = $3,000bn. Quite a bit bigger! The US S&P500 index is the benchmark US index – and the smallest of those has a market cap of around $15bn – The News Corporation.

• Mid Cap – in the UK, the mid-cap index is the FTSE250 with companies ranging from Mkt Caps of £0.5bn (PZ Cussons) up to £4.2bn (EasyJet)
  • But in the US, mid-cap companies have a market cap of around $2 billion to $10 billion. Some examples are PayPal, Square, Fox Corporation. Mid-caps can be considered established firms with potentially more room for growth.

• Small Cap – in the UK this comprises all the remaining companies, down to a few million GBP. In the US, small cap companies have a market capitalization between $300 million to $2 billion. Examples are Etsy, Fiverr, 2U. These younger companies have high growth potential but also more risk.
  • In the US, Apple has a market cap of around $3trn = $3,000bn. Quite a bit bigger! The US S&P500 index is the benchmark US index – and the smallest of those has a market cap of around $15bn – The News Corporation.

• Mid Cap – in the UK, the mid-cap index is the FTSE250 with companies ranging from Mkt Caps of £0.5bn (PZ Cussons) up to £4.2bn (EasyJet)

But in the US, mid-cap companies have a market cap of around $2 billion to $10 billion. Some examples are PayPal, Square, Fox Corporation.

Mid-caps can be considered established firms with potentially more room for growth.

• Small Cap – in the UK this comprises all the remaining companies, down to a few million GBP. In the US, small cap companies have a market capitalization between $300 million to $2 billion. Examples are Etsy, Fiverr, 2U. These younger companies have high growth potential but also more risk.

Market Cap in Investment Analysis

Market capitalization is used in investment analysis to help investors screen for buying opportunities and red flags:

• Value – Comparing market cap to revenues/earnings (for similar companies) gauges if a stock is undervalued or overvalued. Lower ratios may signal an undervalued stock with upside.
• Growth Potential – Smaller caps tend to have higher growth rates. Assessing P/E ratios or EV / EBITDA can help evaluate growth expectations priced into the market.
• Risks – A high market cap with low revenues may indicate overvaluation as well as potential higher growth expectations. Rapidly declining market cap might signal fundamental issues.
• Sector/Industry – Comparing market caps of companies within sectors gives a sense of relative value and size.
• Diversification – Investors can blend large, mid and small cap stocks across sectors into their portfolio to create a diversified portfolio based on market caps.

DCR Across Industries

Acceptable DCRs can vary from industry to industry. A high growth technologically-oriented firm might have a high DCR reflecting a low dividend, allowing the company to focus on reinvesting cash in growth.  For many years Microsoft and Apple did not pay dividends.  At that time Bill Gates’ publicly stated view was that the best thing Microsoft could do with profits was reinvest in growth.  The mature highly cash generative sector of fast-moving consumer goods “FMCG” is characterise by companies with lower dividend cover.  This simply reflects their high cash generation, stability of profits and relatively small capex required to fund organic growth.  

Corporate boards of mature businesses will often have an explicit policy regarding maintaining a specific  DCR or dividend payout ratio, understanding that dividends signal stability and inherently influence stock prices. A weakening DCR might shake investor confidence, prompting a re-evaluation of investment strategies. 

Common Misconceptions in Calculating Market Cap

One of the primary errors in calculating Market Capitalization is not using the current share price in the calculation. Market cap must reflect the most recent trading price to provide an accurate representation of a company’s current market value.

Overlooking fully diluted shares outstanding is another frequent mistake. This figure includes all shares currently issued plus those that could be issued through conversion of convertible securities or through the exercise of options and warrants.

Ignoring this aspect can lead to a significant underestimation of a company’s market cap, especially in the case of companies with a large number of potential shares that could enter the market.

Market Cap and Investment Styles

Market capitalization plays a pivotal role in shaping investment styles:

• Value investors typically gravitate towards large-cap stocks, attracted by their stability, strong market presence, and regular dividend payouts. These stocks are often considered ‘safer’ investments, especially during economic downturns.
• Growth investors often favour small or mid-cap stocks, enticed by their higher growth potential. These companies, while possibly more volatile, offer the possibility of significant returns as they expand and capture market share. However, these investments also come with higher risk, including the potential for greater price swings and liquidity concerns.

Therefore, an investor’s preference towards large, mid, or small-cap stocks is often a reflection of their risk tolerance, investment horizon, and growth expectations. A balanced portfolio may include a mix of different market caps to leverage the advantages of each category while mitigating associated risks.

Having said this, beware that large cap tech stocks also be volatile as well as holding significant growth potential – take MS, Apple, Meta and Amazon!

Limitations of Market Cap as a Sole Investment Metric

While market capitalization is a crucial indicator of a company’s size and an essential tool in portfolio diversification, it should not be the sole metric for investment decisions. For example:

• Debt – Market cap does not account for a company’s debt, which can significantly impact its overall financial health. A high market cap company with substantial debt might be riskier than a smaller company with minimal debt.
• Earnings – Market cap does not reflect a company’s earnings, cash flow, or profitability, which are vital for assessing its true financial performance and potential for growth.
• Contextual Factors – Market cap can overlook important factors such as industry trends, management quality, and competitive dynamics.

Market cap is a valuable tool for initial screening and comparison, but you should never solely rely on it.

Real-World Examples of Using Market Cap

Here are some ways investors utilize market cap analysis:

• An emerging social media company has a market cap of $5 billion despite little revenue. This extremely high ratio indicates speculation and overvaluation.
• An oil company has seen its market cap plunge 30% in one year along with lower oil prices, sales, and earnings per share. This signals fundamental challenges in the industry.
• A regional bank has a market cap of only $100 million compared to rival banks of $500 million in the same city, with similar customer reach. The relatively low market cap indicates the smaller bank could be undervalued. It could also be an indicator that its customer base is higher risk and comes with a greater risk of loan default!
• A biotech firm has a promising new cancer drug entering Phase 3 trials. Its market cap is $300 million, quite low for the industry. If trials succeed, market cap could double or triple.

In summary, market capitalization is a simple but powerful metric that investors use to value companies, gauge size, assess risk and growth, and compare within industries. It provides a quick way to analyse stocks and sectors when making investment decisions or diversifying portfolios. The market cap calculation and classification system allows for efficient analysis across the stock market. It will also give you a measure of how concentrated a stock market index is. For example, investing in an S&P500 index fund you may think you are diversified, but the largest 4 companies make up 20% of the index. That’s not diversification to me!