Understanding Market Capitalization
Market capitalization (or "market cap") is a useful figure to examine when trying to understand a company's structure and profitability, and therefore a stock's value. Market capitalization can be used to determine a variety of key performance metrics, including price-to-earnings and price-to-free-cash flow.
Market capitalization refers to the total dollar market value of a company's outstanding shares. It is thus calculated by multiplying the total number of a company's shares by the current market price of one share. The investment community uses this figure to determine a company's size, and basically how the stock market is valuing the company.
Market cap is useful in categorizing stocks based on their absolute size (e.g., big-cap vs. small-cap stocks), and it is also used as an input in various financial ratios and other metrics. Read on to see how market cap is used to evaluate stocks.
Key Takeaways
- Market capitalization is the total dollar value of all of a company's outstanding shares.
- It's determined by multiplying the company's stock price by its total number of outstanding shares.
- Investors can use market capitalization to assess the value of a stock they are considering buying.
- Market capitalization is a key measure of profitability that is also used in equations to determine price-to-earnings and other significant metrics.
- Market cap is generally broken down as micro-cap, small-cap, mid-cap, large-cap, and ultra or mega-cap.
Performance Metrics That Use Market Cap
There are a number of popular valuation ratios that include market capitalization that investors should look at when considering buying a stock. These ratios include:
- Price-to-earnings(P/E) ratio: Calculated by dividing market cap by 12-month net income; can reference trailing earnings or projected future earnings
- Price-to-free-cash-flowratio: Calculated by dividing market cap by 12-month free cash flow (derived by subtracting capital expenses from cash flow from operations; can also use historical or projected returns
- Price-to-book (P/B) value: Calculated by dividing market cap by the company's total shareholder equity (i.e., the difference between its total assets and liabilities).
- Enterprise-value-to-EBITDA (earnings before interest, taxes, depreciation, and amortization): Functions similarly to the price-to-earnings ratio; enterprise value is calculated by totaling the market value of common and preferred equity, minority interest, and net debt.EBITDA measures operational returns in the short term.
Generally, large-cap stocks experience slower growth and are more likely to pay dividends than faster-growing, small- or mid-cap stocks.
Market Cap Types
There is no official barrier for different categories of stocks based on size, but large (big) capsare often companies with market caps over $10 billion, whilemid-capsare $2 billion to $10 billion, and small capsare under $2 billion. There are further categories that investors will sometimes consider, such as micro caps, referring to small-cap stocks that are under $250 million, and ultra or mega-cap stocks, which are large caps that are over $50 billion.
Market capitalization is used to set investor expectations and shape investment strategy. Different types of investment strategies focus on the various market cap groups, and different valuation methods are applied depending on company size. Very large market caps are usually associated with mature, low-growth companies that pay dividends. Small caps are often growth companies with higher-risk profiles and generally do not pay dividends.
$2.9 trillion
Apple Inc. (AAPL) has the largest market cap of any company in the world. As of Q2 2022, it is worth nearly $3 trillion. It is followed by Microsoft (MSFT) and Alphabet (GOOG) at around $2.3 trillion apiece.
Why Are Stocks Measured by Market Capitalization?
Market cap is a useful measure of a company's overall value, as the market sees it. Because different corporations have different amounts of shares available for trading, the market cap produces an apples-to-apples comparison regardless of the actual price of a company's stock.
Market cap is used to categorize stocks since certain investors look for attributes that accompany companies of different sizes. For instance, large caps tend to be more mature and stable companies that have already experienced a great deal of growth and that capture a large market share. Small caps, on the other hand, tend to be more volatile but may also be potential growth opportunities.
It is best to compare stocks of like market cap to one another. For instance, a small-cap growth stock should not be compared with a large-cap value stock.
How Does Market Cap Affect Stock Price?
Market cap does not influence share prices. It works the other way around. Market cap is arrived at by multiplying the share price by the number of shares outstanding. So when a stock's price rises, so too does its market cap.
Is There Such a Thing as a Good Market Cap for a Stock?
This is all a matter of perspective. Sometimes small-cap stocks outperform larger stocks, but they also tend to be riskier or more volatile investments. Once a company grows very large, it may no longer be as nimble or able to take advantage of new growth opportunities. At the same time, large caps tend to be stable investments and may be more likely to pay dividends to shareholders.
