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Market Cap

Market Cap or Market Capitalization is the market value of a publicly traded company's outstanding shares. Market capitalization is equal to the share price multiplied by the number of shares outstanding. Since outstanding stock is bought and sold in public markets, capitalization could be used as an indicator of public opinion of a company's net worth and is a determining factor in some forms of stock valuation. Market cap reflects only the equity value of a company. A firm's choice of capital structure has a significant impact on how the total value of a company is allocated between equity and debt. A more comprehensive measure is enterprise value (EV), which gives effect to outstanding debt, preferred stock, and other factors. For insurance firms, a value called the embedded value (EV) has been used. Market capitalization is used by the investment community in ranking the size of companies, as opposed to sales or total asset figures. It is also used in ranking the relative size of stock exchanges, being a measure of the sum of the market capitalizations of all companies listed on each stock exchange. In performing such rankings, the market capitalizations are calculated at some significant date, such as June 30 or December 31. The total capitalization of stock markets or economic regions may be compared with other economic indicators. The total market capitalization of all publicly traded companies in the world was US$51.2 trillion in January 2007 and rose as high as US$57.5 trillion in May 2008[5] before dropping below US$50 trillion in August 2008 and slightly above US$40 trillion in September 2008. In 2014 and 2015, global market capitalization was US$68 trillion and US$67 trillion, respectively.[1]


Misconceptions About Market Caps[2]
Although it is used often to describe a company, market cap does not measure the equity value of a company. Only a thorough analysis of a company's fundamentals can do that. It is inadequate to value a company because the market price on which it is based does not necessarily reflect how much a piece of the business is worth. Shares are often over- or undervalued by the market, meaning the market price determines only how much the market is willing to pay for its shares. Although it measures the cost of buying all of a company's shares, the market cap does not determine the amount the company would cost to acquire in a merger transaction. A better method of calculating the price of acquiring a business outright is the enterprise value.

Two main factors can alter company's market cap: significant changes in the price of a stock or when a company issues or repurchases shares. An investor who exercises a large number of warrants can also increase the amount of shares on the market and negatively affect shareholders in a process known as dilution.


Market Cap - Importance, Range and Segmentation[3]
Why is market cap important, and how should you use it? Market cap is one of the best measures of a company's size, and size can tell you a lot about what to expect if you buy its stock.

In general, large companies tend to have more stable and mature businesses, having proven themselves over time and weathered difficult business conditions to emerge stronger. However, the growth prospects for large companies tend to be more limited, because they've already taken advantage of their primary opportunities to grow to their current size. By contrast, smaller companies have a lot more room to grow. However, smaller companies tend to be younger, with riskier business models that haven't yet proved themselves over time. Their odds of failure are significantly higher than those of larger companies. Here's a quick breakdown of the way market capitalization ranges are often segmented and discussed within the stock market:


Market Cap Segments
source: The Motley Fool

  • Large Cap Stocks

Large-cap stocks have market capitalizations of $10 billion or more. Most of the best-known companies in the world are large caps, and some investors break out stocks with market caps of more than $200 billion into a separate category as mega-cap stocks. Most large-cap companies have mature business models and generate substantial amounts of revenue. They often earn significant profits and have considerable market share within their industries, making them leaders in their fields. They're more likely than smaller companies to pay sizable dividends to their shareholders, because their businesses tend to produce greater amounts of available cash. On the other hand, large-cap companies have often already gone through their period of maximum growth. As a result, even successful large-cap companies that pay healthy dividends and whose shares go up in value consistently won't always be able to match the massive returns that smaller companies can achieve.

  • Mid Cap Stocks

Mid-cap stocks have market caps in the range of $2 billion to $10 billion, occupying the middle ground between large and small companies. Mid-cap companies are large enough to have made considerable progress in building up successful business models, and that gives their investors some stability and protection against future challenges those companies will face. However, they're small enough that they give investors a longer runway for future growth than a large-cap stock. That said, mid caps also face the difficult task of catching up to and surpassing larger rivals in their industries, and they don't have as many financial resources at their disposal. It's important when investing in mid-cap stocks to know their history. Some mid-cap companies are still in their high-growth phase, while others have reached their full potential in relatively small niche industries of limited size. Still others are older companies that used to be large caps but have seen their businesses lose steam. Any of these can be good investments under the right circumstances, but they can have very different characteristics in terms of growth potential, dividend income, and valuation.

  • Small Cap Stocks

Small-cap stocks have market capitalizations of between $300 million and $2 billion. Some people also include within this category even smaller companies with market capitalizations of $50 million to $300 million, while others put those tiny stocks into a separate group as micro-cap stocks. Small-cap companies tend to be younger than large caps or mid caps, and they often have a much shorter track record as operating businesses. Small caps often have considerable growth potential, but investors in small caps face a lot more uncertainty about their future. In many cases, small caps have to upend much larger competitors in order to stake their claims within a given industry, and for every small company that succeeds, many fail. Over time, small-cap stocks have historically produced higher average returns than large-cap stocks, but their performance has been more volatile along the way. That requires small-cap investors to have a greater risk tolerance than those who concentrate on larger stocks. Those with long time horizons can typically weather the ups and downs of small-cap stocks and therefore have a better chance of enjoying the reward of greater returns.


Market Cap vs. Enterprise Value[4]
A company's market cap can also be referred to as its equity value and takes into consideration only the value of its shares. A broader way of assessing a company's worth is enterprise value. To calculate a company's enterprise value, you add its market cap to the value of its outstanding preferred shares (if applicable), any minority interest in the company (if applicable), and the market value of its debt and then subtract its cash and equivalents. You can use enterprise value instead of market cap in common metrics for evaluating companies, such as price-to-earnings and price-to-sales ratios. Doing so may help you more accurately determine the worth of companies with large cash holdings.

  • Market Cap Is a Good Way to Value Companies

Market cap is a relatively good way to quickly value a company. That's because stock prices are generally based on investors' expectations of a company's earnings. As earnings rise, stock traders will bid more for the stock price. Including the number of shares in the calculation offsets the impact of stock splits. Market cap would be a great way to value companies if they all had the same price to earnings ratio. Investors consider some industries to be slow growing or stodgy. Their stock prices are undervalued, and so are the market caps of companies in that industry. There are several other ways to determine the value of a company. One good way is to determine the net present value of its future cash flow, or income. This gives the buyer an idea of what the return on investment will be. If a company's market cap is lower than the net present value of its cash flow, then it is undervalue, and a candidate for takeover. Another more conservative approach is to determine the total resale price of all a company's assets. The drawback is that some assets would be difficult to value. Others may be worth more than their resale value. However, this is a good approach for a company that just wants to buy the company and sell off the assets for quick cash. During the "Greed is good" days of Ivan Boesky, many companies were worth much less than their resale value. Conversely, during the Internet bull market in 1999, many companies' capitalization values were worth far more than their income or asset value. Irrational exuberance drove stock prices beyond a reasonable valuation. When the tech bubble burst, it led to the recession of 2001.


See Also


References

  1. What Does Market Cap Mean? Wikipedia
  2. Misconceptions About Market Caps Investopedia
  3. Market Cap - Importance, Range and Segmentation The Motley Fool
  4. Market Cap vs. Enterprise Value the balance