Use Market Cap When You're Considering Stocks

When deciding whether to buy a company's stock, don't just focus on the price of one share. Consider its market capitalization, often called "market cap," to understand how the market values the company.

Market cap shows the total cost to buy all of a company's shares, but it may not reflect the company's true worth. It helps categorize publicly traded companies into small-cap, mid-cap, or large-cap groups.

Understanding market cap gives insight into a company's size and can be useful when evaluating investment opportunities.

What Is Market Cap?

Market capitalization, or market cap, is calculated by multiplying a company's current share price by its total outstanding shares. It represents the value of a company's stocks in the stock market. There are two common methods used to calculate market cap: the float method and the free-float method.

The float method considers the total number of shares a company has that are publicly owned and available for trading. On the other hand, the free-float method excludes shares held by executives, governments, or other private entities that are not available for public trading.

Many major stock market indexes, like the Dow Jones Industrial Average and the Standard & Poor's 500 Index, use the free-float market cap for their calculations.

Note

Market capitalization (market cap) is a measure of a company's size in the stock market. For example, if the total value of the stock market is $49 billion and a particular business has outstanding shares worth $12.25 billion, its market cap represents one-quarter of the overall stock market value.

Think about these two companies with vastly different stock prices but somewhat comparable market caps:

Company 1:

Company 2:

Merely observing their individual share prices might lead you to think that the first company holds more value, but that's not necessarily true. Each person has their own perspective on what holds value to them. However, considering the second company has a greater number of shares available, investors generally attribute a higher value to its shares compared to the first company.

Market Cap Systems

When assessing companies, market cap is useful for comparing similar ones. The classification for small, mid, and large-cap companies varies, and it can shift with changes in the overall market. Here's an example system:

Use Market Cap When You're Considering Stocks

Starting from June 3, 2021, Standard & Poor's (S&P) began utilizing specific market-cap limits and ranges for its large, mid, and small-cap indexes.

Certain firms and analysts include micro-caps (the smallest publicly traded companies) and mega-caps (the largest companies) in their assessments.

Small-cap stocks usually offer higher potential for price growth because these companies have more room to expand. However, they may come with higher risks as their future performance is less predictable.

Large-cap stocks, while having less growth potential, are considered safer investments due to their established track records. Mid-cap stocks typically sit between small and large caps in terms of growth potential and investment safety.

Market Cap vs. Enterprise Value

A company's market cap, also known as its "equity value," measures the value of its shares. On the other hand, enterprise value provides a more comprehensive assessment of a company's overall worth.

To calculate enterprise value, add the company's market cap to the value of its outstanding preferred shares, if any, and any minority interests in the company. Then, include the market value of its debt and deduct its cash and equivalents.

Note

Cash and equivalents are subtracted when calculating enterprise value because if the company were to be acquired, that cash would typically be included in the purchase. Therefore, it's excluded from the theoretical takeover price of the company.

Instead of relying solely on market cap, you can consider enterprise value when assessing companies using various metrics like enterprise-value-to-EBITDA or enterprise-value-to-revenue. This approach might offer a better evaluation, especially for companies with significant cash reserves.

Frequently Asked Questions (FAQs)

Why is market cap important?

Market capitalization (market cap) represents the overall value of a company in the stock market. It showcases the company's value to investors, providing insight into its size, activities, and available resources. This information assists in evaluating the potential risks and rewards associated with investing in the company.

How does market cap affect stock price?

Market capitalization and stock price both convey information about a company's value, but they represent it in different ways. The market cap is the total value of a company's outstanding shares, calculated by multiplying the share price by the number of shares. On the other hand, the stock price is the value of one share, obtained by dividing the market cap by the total number of outstanding shares.
It's important to note that The Balance doesn't offer tax, investment, or financial services advice. The information provided here doesn't consider the specific needs or financial situations of individual investors and might not be suitable for everyone. Investing always carries risks, and past performance doesn't guarantee future results. It's essential to understand these risks before making any investment decisions.

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