Market Capitalization, or simply market cap, is a measure of how much a company’s current outstanding shares are worth. It is an estimation that employs the current price of a business’ shares to determine the total value of its equity instruments, including both common and preferred shares.
What is Market Cap?
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The market capitalization figure, also known as ‘market cap’, is a widely employed metric in the financial world to help analysts, investors and institutions to measure the size of a given business. Four main categories have been created to classify businesses depending on their market cap, and these are:
- Large Cap: $10 billions or more
- Mid Cap: Between $2 and $9.99 billions
- Small Cap: Between $300 million and $1.99 billions
- Micro Cap: Less than $300 million
These capitalization numbers don’t have any relationship with sales or even with the operational size of the business, as they are exclusively related to the company’s equity portion. In contrast, the Enterprise Value (EV) of the business, combines both equity and debt to value the entire business assets.
Large and Mid Cap companies are often seen as more stable businesses, commonly with many years of operations and well positioned in their respective markets. Yet, the market cap shouldn’t be used as an indication of the financial soundness of the business, as many other elements such as its debts and earnings should be considered carefully before categorizing them as such.
Market Capitalization Formula
The market cap formula for a business is calculated like this:
Market Cap = (Price of Common Shares * Common Shares Outstanding) + (Price of Preferred Shares * Preferred Shares Outstanding)
Market Capitalization Equation Components
Price of Common Shares: The current market price of common shares.
Price of Preferred Shares: The current market price of preferred shares.
Shares Outstanding: The number of shares currently available to be traded in the open market.
The market capitalization (or “cap”) of a stock is simply the market value of all outstanding shares and is computed by multiplying the market price by the number of outstanding shares. For example, a publicly held company with 10 million shares outstanding that trade at US$20 each would have a market capitalization of 200 million US$.
Market Cap Example
AI Security is a firm that designed an integrated security system for households and industries, that instantly notify the authorities of any unauthorized access to the premises, to prevent crime and protect homeowners and companies from thieves.
The company’s system has been patented and sales skyrocketed since it was first introduced to the market. The company is currently traded in the New York Stock Exchange and it has more than 56,320,000 common shares outstanding that are currently price at $24.3 each. The current market capitalization of the company is, therefore:
Market Cap = $24.3 * 56,320,000 = $1,368,576,000.
The company is considered a Small Cap right now, given the size of its market cap.
Lately, the CEO decided it was time to introduce some preferred shares, to obtain additional financing at a decent cost, without affecting the current ownership structure. The issue involves the creation of 8,700,000 shares at an initial price of $5 each. After they were first introduced, the price of the shares increased 50%, and ended up at $7.5.
After this move, the company’s market cap moved up, and ended up at:
Market Cap = ($24.3 * 56,320,000) + ($7.5 * 8,700,000) = $1,433,826,000.
The company is still considered a Small Cap, yet is only $600 million away from becoming a Mid Cap business.
Market Capitalization Ratio Analysis
A business Market Capitalization doesn’t say much by itself, except for the fact that the business equity portion is large. It will be justified, though, to estimate that if a business has a large market cap, the size of the business will be large too. Yet, even though the market cap may be a clear indication of the size of the company, it is not an indication of how profitable or financial sound it is.
Investment firms often define these capitalization sizes in order to classify businesses, as it makes it easier for them to screen in and out businesses that fit their investment criteria. For example, some firms only invest in mid and large cap businesses, as the size of their Assets under management (AUM) is too high as to spend time analyzing and investing in small or micro caps.
Also, classifying businesses by their capitalization also allow analysts to understand which businesses ‘move’ the markets. For example, a 50% decline on a small cap stock may not cause a large impact in the overall’s market performance. Yet, if a large cap declines in price by 20%, the impact that decline will have on the overall market performance will be much more significant.
Some indexes are also designed to track a particular number of stocks based on their caps. There are indexes that track small, mid and large caps only, and this also allows individual and institutional investors to follow their investment philosophy or criteria even if they are purchasing an index.
As seen in the formula, the market capitalization of the business can be influenced mainly by 2 elements. The price of its shares (either common or preferred) and the volume of its shares. A change experienced by any of these will impact the market capitalization of the business. Therefore, it is important to identify the source of a market cap increase or decrease before jumping to conclusions.
Market Cap Uses, Cautions, Pitfalls
While an increase in the market capitalization of a business may be an indication that its value has been growing, this growth can also be caused artificially by issuing shares at lower introduction prices. For example, let’s say a business first IPO resulted in 1,000,000 shares originally priced at $10 per share. This would value the business at $10,000,000. If the business subsequently issues a second round of common shares and the only way to entice investment bankers to purchase them is to reduce the price to $9.5, even though the market capitalization will increase, the increase is not necessarily caused by a higher perceived value of the firm. Instead, it is being pumped by the introduction of new shares.
Furthermore, even though mid and large cap businesses may be seen as stable and financially sound ventures, investors must be aware that only be analyzing a company from several different perspectives such as its profitability, debt and growth potential, they can conclude accurately that the business is worth their investment, as the market capitalization by itself is not an indication of a business soundness or potential in any of these aspects.
When reading a mutual fund prospectus, you may see the term “median market cap.” This is just the median of the capitalization values for all stocks held by the fund. The median value is the middle value; i.e., half the stocks in the fund have a market capitalization value below the median, and the other half above the median. This value helps you understand whether the fund invests primarily in huge companies, in tiny companies, or somewhere in the middle.