Market Capitalization

Market Capitalization Definition

Market Capitalization popularly known as market cap is the total market value of all the outstanding shares and is calculated by multiplying the outstanding shares with the current market price, investors use this ratio to determine the size of the company rather than using total sales or total assets. For example, if the outstanding shares of Company X is 10,000 and the current price per share is $10, then market cap = 10,000 x $10 = $100,000.

Formula Explained

Market Capitalization = Outstanding shares * Market Price of each share

There is always confusion between market cap and equity value of the company. But market capitalization is not the equity value of the company. Market capitalization calculation is based on market price; whereas, equity value is calculated on the basis of book value.

Most investors get busy buying stocks of other companies depending on the market capitalization of those companies. But there is a flaw which we need to look at.

Market capitalization can’t be the sole domain of valuation of a company. That means market capitalization doesn’t equal the “takeover value” of the firm. So it’s flawed. What’s important for investors to consider is to understand “enterprise value” when they want to go ahead and buy the stocks or invest in the said company.

top-market-capitalization

Here’s why enterprise value is given a higher rating than market capitalization.

  • First, enterprise value takes into account the total debt and cash & cash equivalent of the company, which market capitalization doesn’t take into account. That means if we look at “enterprise value,” we would understand the takeover value of the company. Have a look at the formula of “enterprise value” of the company to understand this clearly –

Enterprise Value = Market Capitalization + Total Debt – Cash

Many analysts take preferred stocks and many current assets into account to provide a more accurate figure of enterprise value.

  • Second, if we take only market cap into account, we would miss out on the “takeover value” of the firm. For example, if Company A and Company B both have similar Market Cap. And Company A doesn’t have any debt, but some cash, and Company B have a lot of debt and no cash, the “takeover value” would be completely different from the investors.

So, if you want to consider market cap calculation as the sole domain, think again. You may be missing out on the total debt and cash of the company, which you need to take into account.

also, look at Market Cap vs. Enterprise Value and Equity Value vs. Enterprise value

Interpretation

It is an important concept. But as mentioned in the above section, this is not the only thing that investors need to take into account before thinking about investing in the company.

But if we think about market cap, there are three types which investors need to pay heed to – small-cap, middle cap, and large-cap.

Small Market Cap companies

  • When a company’s market cap lies between the US $500 million to the US $2 billion, then it would be called as a small-cap company.
  • This range is not set in stone, which means – you can consider that if the market cap of the company is under the US $2 billion, it’s a small-cap company.
  • Many investors avoid small-cap company thinking that this sort of company would not generate much return.
  • However, a small-cap company can turn out to be the biggest advantage for investors who have a small capital to invest in a company. Here’s why. Small-cap companies are not as famous as large or middle cap companies. Thus, their share price is usually much cheaper than the middle cap and large-cap companies.
  • And small-cap companies have much greater growth potential. So if you invest in small-cap companies, you would yield better returns even in the economic downturn.

Middle Market Cap Companies:

  • Middle cap companies are those companies that have a market capitalization of US $2 billion to the US $10 billion. These companies have their own advantages.
  • To investors, these companies are safer to invest in because there is little or no chance of them to go belly up in the future.
  • So during an economic downturn, when smaller cap companies may go out of business, middle cap companies won’t file for bankruptcy. Moreover, middle cap companies would be having better growth potential than large-cap companies because they have not yet reached the saturation point so as to stop growing further.
  • And as middle cap companies have more transactions and better hold of companies’ capital, they usually pay dividends to shareholders, which small-cap companies can never do.

Large Market Cap Companies

  • Large-cap companies are big guys, and they have a market capitalization of over US $10 billion. They are also called as blue-chip companies.
  • Large-cap companies are the safest company to invest in because they usually pay dividends to shareholders, and if any economic downturn affects the whole economy, they would be able to handle it much better than mid or small-cap companies.
  • But large-cap companies have limited or no growth potential because they have already grown so much that their share price has increased a lot more. So nobody would buy a large number of shares from them at a hefty price.
  • Another disadvantage of large-cap companies is that – investors can rarely get an edge in their investment while investing in large-cap companies because so much information is available to the public.
  • To get an edge in purchasing shares of large-cap companies, you need to do in-depth analyses of their financial statements and balance sheet to be able to understand whether there the companies are undervalued or not to fetch an opportunity.

Example

Let’s take an example to understand this.

We will also illustrate the example of enterprise value so that you can get a comparative analysis of what we are trying to explain.

Example # 1

Here are the details of Company A and Company B –

In US $ Company A Company B
Outstanding Shares 30000 50000
Market Price of Shares 100 90

In this case, we have been given both the numbers of outstanding shares and the market price of shares. Let’s calculate the market capitalization of Company A and Company B.

In US $ Company A Company B
Outstanding Shares (A) 30000 50000
Market Price of Shares (B) 100 90
Market Capitalization (A*B) 3,000,000 4,500,000

Now, if we compare both of these figures (Company A and Company B), we would find that the market cap of Company B is more than Company A! But let’s tweak a few things and calculate Enterprise Value and let’s see how it turns out for investors.

Example # 2

In US $ Company A Company B
Outstanding Shares 30000 50000
Market Price of Shares 100 90
Total Debt 2,000,000
Cash 200,000 300,000

Let’s calculate the Enterprise Value for both of these companies. We will first calculate the market capitalization, and then we would ascertain the Enterprise Value of both of these companies.

The market cap in this example would also be the same as in the previous example –

In US $ Company A Company B
Outstanding Shares (A) 30000 50000
Market Price of Shares (B) 100 90
Market Cap calculation (A*B) 3,000,000 4,500,000

Now, let’s calculate the Enterprise Value –

In US $ Company A Company B
Market Capitalization (X) 3,000,000 4,500,000
Total Debt (Y) 2,000,000
Cash (Z) 200,000 300,000
Enterprise Value (X+Y-Z) 4,800,000 4,200,000

Now, as we have got the enterprise value of both of these companies, you can understand how different the enterprise value is. If the investor would go to invest in a company by looking at the higher cap, he would be misled by the market cap because then he wouldn’t take into account the total debt and the cash. So it’s always better to go for Enterprise Value instead of only depending on a Market cap to decide for a company.

In this case, the enterprise value of Company A is significantly higher than the enterprise value of Company B. So, as an investor, if your goal is to look for the valuation of a company before you decide to invest, the enterprise value would be the calculation you should go for.

Market Cap Calculation

Let’s now calculate the market cap of some top companies.

Please have a look at the table below.

market-capitalization

source: ycharts

Column 1 contains the number of outstanding shares.

Column 2 is the current market price.

Column 3 is the Market Cap calculation = Shares Outstanding (1) x Price (2)

If you want to calculate the Market Cap of Facebook, it is simply the outstanding number of shares (2.872 billion) x Price ($123.18) = $353.73 billion.

Market Capitalization Ranking of Top 12 Biggest Companies 

Enterprise Value is a better measure, we agree, but you need to calculate market cap for getting enterprise value. To understand this better, here’s a list of the top 12 biggest companies (in US billion dollars) so that you can get an idea of how it looks on the chart.

top-12-market-capitlization-firms

Please note that 5 out of the top 6 companies with the largest market cap are the tech companies (Apple, Google, Microsoft, Amazon, and Facebook).

Limitations

As mentioned before, there is one limitation of the Market cap if we want to be precise, and that is this that it doesn’t show the actual figure on the basis of which investors can make a decision. That means the calculation of market cap can be used to find something else, but market cap can’t be the only measuring grid for making a concrete decision.

But enterprise value is the right option if you want to base your decision on purchasing shares on the basis of the “takeover value” of the firm. Because here, we would add total debt and deduct cash and cash equivalent for finding out the actual “takeover value.”

Conclusion

In the end, it can be seen that for every large, middle, or small-cap company, the market cap is an important concept. But if we take into account the interest of investors, market capitalization is not enough. We need enterprise value to come to any conclusion if we think from the perspective of investors.

Video on Market Capitalization

Recommended Article –

This article has been a comprehensive guide to what is Market Capitalization and its definition. Here we discuss how to interpret market cap along with practical examples and its limitations.

 

Meaning, Formula, Market cap calculation, examples, and limitations. Here we also discuss the top 12 biggest companies by Market capitalization, small, middle, and large Mcap companies. You may also have a look at these articles below to learn more about valuations –

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Comments

  1. AvatarBhargava Rushi says

    Hi Dheeraj, This is Rushi from Shell. I subscribed to your emails long back but ignoring the emails so far.. today i spent few minutes and realized you put up some very good material out here. I will be spending good amount of time to read through your articals that help me improve financial acumen.

    Thanks
    Bhargava Rushi (CIMA, CGMA)

    • AvatarDheeraj Vaidya says

      Thanks for your kind words!

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