Market Capitalization – A Comprehensive Guide

Infographic explaining what market capitalization is, its formula, different types, and how to use it.

What Is Market Capitalization?

Market capitalization, also called market cap, is the total market value of a publicly traded company’s outstanding shares. A company’s market cap is calculated by multiplying the total number of outstanding shares with the current market price per share. In other words, market cap measures what a company is worth on the open market, as well as the market’s perception of its future growth potential. Market capitalization reflects what investors are willing to pay for a company’s stock. 

For example, if a company has 100,000 shares, and each stock is currently priced at $25, the company’s market capitalization is $2.5 million (100,000 x $25). 

Shares outstanding include all shares held by all shareholders, including those held by the public, institutional investors, and restricted shares held by specific groups such as executives and company insiders.

Some inexperienced investors might believe that if the current share price of one company is higher than the current share price of another company, then the company with the higher share price is more valuable and therefore a better investment. However, a company’s stock price alone does not represent a company’s actual worth. Using market capitalization is a better way to look at a company, as it represents the current financial value as perceived by the overall market. 

Here is an example that shows that a company whose current share price is higher than another company’s share price, is not necessarily more valuable.

Company X has 500,000 outstanding shares of stock that sell at $100 per share. Its market cap is $50 million dollars.

Company Y has 2,000,000 outstanding shares of stock that sell at $50 per share. Company’s Y market cap is $100 million dollars.

It is clear from this example that although company X’s individual share price is higher, company Y is more valuable.

Market capitalization describes the market size of a company. It is widely used in the investment industry, and it is only one characteristic of a company used in investment analysis. The real value of a company includes not just its market size, but many other factors, some of which are intangible. Market capitalization should be used in conjunction with other stock characteristics, such as price-to-earnings ratio (P/E ratio) and earnings growth estimates.

What Can Increase or Decrease a Company’s Market Cap?

Market capitalization is based on the number of outstanding shares and the price of each share. This means that a change in share price or a change in the number of shares will change the market cap of a company.

Since the market prices of stocks of publicly traded companies change continuously at stock exchanges, the market cap of those companies fluctuates accordingly. This means that when a company exceeds investor’s expectations and investors want to buy more shares in that company, the share price will increase which will result in an increase in the market cap for that company. When a company’s results fall below expectations, and investors want to sell their shares, the share price will go down resulting in a decrease in a company’s market cap.

A change in the number of outstanding shares can also change the market capitalization of a company, however, this does not occur very frequently and involves corporate action. 

One way to increase a corporation’s number of outstanding shares is to issue more shares to raise capital. As more shares are put on the market, the share price might decrease a little but usually not very much. The net result will be an increase in market cap.

A way to decrease a corporation’s number of outstanding shares is when a company decides to buy back some of its shares under a share repurchase program in an effort to improve earnings per share (EPS) ratios. As the number of shares goes down, so will the market cap of the company.

Other ways a company can change the number of outstanding shares are exercising employee stock options (ESO) or issuing or redeeming other financial instruments.

Please note that the market cap does not change because of a stock split or dividend. At a stock split, the increase in outstanding shares is compensated for by the proportionate decrease in the face value of the stock price.

For example, an investor owns 100 shares that are each worth $500. At a stock split of 2 for 1, the shares will be converted to 200 shares and the market price of each share will drop to $250. The market value of the investment remains $50,000 even after the split.

What Is Free-Float Market Capitalization?

Free-float market capitalization, also called a float-adjusted market cap, considers only those shares which are readily available for trading in the market. It excludes locked-in shares, such as those held by insiders, institutions, government agencies, and promoters. The float-adjusted market cap provides a more accurate picture of how investors value a company’s stock.

Free-float methodology market capitalization is calculated by taking the market price of a company’s share and multiplying it by the number of shares readily available in the market. The number of shares readily available is calculated by taking the number of outstanding shares and reducing it by the number of “locked-in” shares (shares that are not available for trading).

Free-float market capitalization has been adopted by many of the world’s major indexes such as the S&P 500, MSCI World Index, and the Financial Times Stock Exchange (FTSE in London). In addition, many index funds and ETFs (exchange-traded funds which are types of mutual funds that mirror a market index) use it as well. 

As the number of readily available shares used in this free-float calculation is smaller than the number of total shares outstanding used in the full market cap calculation, the free-float market cap will be lower.

The free-float market cap can be calculated as follows:

Free-Float Market Cap (FFM) = share price (in $) x (number of outstanding shares – locked In shares)

Example of Market Capitalization and Free Float Market Capitalization

  • Share Price = $50
  • Number of outstanding shares (including locked-in shares) = 1 million
  • Number of locked-in shares = 200,000

Market Cap: $50 X 1,000,000 = $50 million

Free-Float Market Cap: $50 X (1,000,000 – 200,000) = $40 million

As can be seen from the example above, the free-float market cap is smaller than the full market capitalization.

Types of Market Caps and Investment Strategies

Traditionally, companies were divided into 3 types of market capitalization, large-cap, medium-cap, and small-cap. More recently 3 other types were added, namely mega-cap, micro-cap, and nano-cap.

There does not seem to be one official definition for each type and exact cut-off values. Especially because the dollar size of each cap has to be adjusted over time due to inflation and overall market valuation. For example, in 1950 a market valuation of close to 1 billion dollars was considered a large-cap, however, today it is considered a small-cap. 

Nano-Cap: Stocks of small, publicly traded companies with a market cap of less than $50 million. They are usually penny stocks and are considered the riskiest investments due to their small size, the potential for manipulation, volatility, and lack of available information and history. They normally trade in the over-the-counter bulletin board or pink sheet.

Micro-Cap: Stocks with a market cap between $50 million and $300 million. Although a little larger than nano-caps, micro-cap stocks are also considered high-risk investments. Many have no track record and no reportable revenue. In-depth research should be done before investing in micro-caps.

Small-Cap: Small-cap companies have a market capitalization between $300 million and $1 billion. Generally, these are smaller companies, and many of them recently went public and held their initial public offerings (IPOs). These types of young companies are considered riskier to invest in than larger companies and they are more likely to default during an economic downturn. However, small-cap companies can also prove to be very profitable for an investor as they offer rapid growth potential when managed correctly. In addition, these smaller companies are often in niche markets and their small-cap stocks can turn out to be very profitable for investors who are willing to take a higher risk and invest in them. 

Examples of small-cap companies today are Bed, Bath & Beyond, and GoPro. 

There are two benchmarks that track small-cap companies – the S&P Smallcap 600 and the Russell 2000.

Mid-Cap: Mid-cap companies typically have a market capitalization of between $1 billion and $10 billion. These companies are less risky than small-cap companies, but they may not have the same growth potential. Mid-caps offer good opportunities for investors with medium risk tolerance levels.  

Growth stocks represent a significant portion of the mid-caps. With that growth comes the opportunity for faster and higher profits, but also the potential for faster and larger losses. However, in the time of recession, small-cap companies may go out of business, but the mid-caps will most likely not as they will benefit from low-interest rates and the credit they need for future growth. Mid-cap companies sometimes are household names, just not on a national or international level. 

Examples of mid-cap companies today are Dollar Tree Inc. and Cracker Barrel. 

There are several benchmarks that track mid-cap companies, two of them are the S&P MidCap 400 and the Russell Midcap.

Large-Cap: Market capitalization for these larger companies is between $10 billion and $200 billion. Large-cap stocks offer the least risk as these large public companies have the financial capabilities to survive economic downturns. Typically, they are market leaders. These are established, well-known companies with more assets, capital, and a larger revenue and profit stream than smaller companies. However, these large caps do not typically offer the aggressive double-digit growth that smaller companies might offer. What large-caps do offer though, is stability, security, and an increase in value over time. In addition, they often also reward their shareholders with dividends.

Examples of large-cap companies today are IBM and General Electric (GE). 

There are several benchmarks that track large-cap companies, two of them are the ishares S&P 100 ETF, and Schwab U.S. Large-Cap Value ETF

Mega-Cap: Mega-cap companies typically have a market cap of $200 billion or larger. They are the largest publicly traded companies by market value, and represent the leaders of a particular industry sector or market. They are well-known, stable, and usually have large cash reserves on hand. Very few companies make it into this category. Amazon, Microsoft, and Apple are examples of mega-caps.

Both mega and large-cap stocks are also called blue-chip stocks and are considered to be relatively stable and secure as they have a solid history of sustained growth and good future prospects. 

Uses of Market Capitalization

Market cap describes the market value of a company. In other words, it measures what a company is worth on the open market, as well as the market’s perception of its future growth potential. 

The size and value of a company affect the level of risk an investor can expect when investing in its stock. It also affects what the return on the investment might be over time. Categorizing companies by market cap helps investors create a balanced portfolio that is optimized for long-term growth. 

Generally, investors who want to invest in the long-term might want to consider some riskier investments in their portfolio, as a longer timeline means more opportunity for their portfolio to recover in case of an economic downturn. Younger people starting to save for their retirement can benefit from the potential growth of small- and mid-cap companies. Investors who don’t want to take a lot of risks should invest more heavily in less-volatile large- and mega-caps, with a lower allocation to small- and mid-caps.

Market capitalization can also be used to calculate many critical performance metrics that are used by investors to analyze stocks before considering investing in them.

Some of these key performance metrics include:

  • P/E Ratio: Price-to-earnings ratio is calculated by dividing the market cap by the last 12-months of net income. 
  • The Price To Free Cash Flow: This is calculated by dividing the market cap by 12-month free cash flow. 
  • Price To Book Value: This is calculated by dividing the market cap by shareholder equity.  

A Free-float market cap is used for weighting shares that make up an index. A stock with a higher market cap gets a higher weighting in an index. Most indexes such as the S&P 500 use market cap. Indexes not only represent the overall market expectations but are also used as benchmarks to track the performance of different funds and individual investments.

Often, market-cap data is also used to manage mutual funds.  Some mutual funds hold stock in one particular market cap category, such as small-cap or large-cap funds. This allows investors to buy many different stocks in one transaction.

Please note that market cap does not take the debt of a company into account nor returns such as dividends.

Market Cap vs. Enterprise Value (EV)

These two metrics are the most common ways to assess a company’s value. Both of these metrics have a different way of looking at the company’s worth, and therefore it is a good idea for an investor to consider both to get a clear picture of the company’s value. 

Market Capitalization is the market value of the outstanding shares in dollars. Enterprise Value (EV) is a metric used to value a company and is usually considered a more accurate measure of value than market capitalization. The enterprise value of a company shows how much money would be needed to buy that company.

Enterprise Value, or firm value, is an economic measure reflecting the true value of a business. It is a sum of claims by all claimants: creditors and shareholders. It is calculated by adding market capitalization and total debt (short and long-term debt), then subtracting all cash and cash equivalents.

Capitalization Weighted Indexes vs. Weighted Price Indexes

Indexes in the market are often weighted in proportion to their price or market capitalization and their overall returns are significantly affected by the type of weighting methodology used by the index.

Capitalization weighting type is the most widely used methodology and most indexes in the world use this method. The leading capitalization-weighted index in the US is the S&P 500 index.

Full Market capitalization weighting for indexes is very seldomly used as it can change the return dynamic of the index because companies often have plans for stock splits, and issuing stock options, and this should be taken into consideration.

In a price-weighted index, member companies weigh in proportion to their price per share. In the price-weighted index, higher-priced stocks receive higher weighting and will have more influence on the returns. There are very few indexes that are price-weighted in the trading market.  The Dow Jones Industrial Average is an example of a price-weighted index.

Conclusion

Market capitalization is a good way to quickly value a company. It shows investors the size of a company, and it helps them understand what kind of growth, volatility, and risk they can expect by owning that stock.

In order for an investor to make an informed decision, company size is just part of the puzzle. A more detailed analysis of the company, its financial situation, the market, the market segment it is part of, and the general economic situation should be conducted. In addition, an investor needs to take into consideration their investment objectives, their investment time frame, and their risk tolerance. Only then is an investor ready to make an informed decision on whether to buy a stock or not.

Vikram R
Vikram Raghavan is a value investor, technologist, and Finexy co-founder. In addition to stock market investing, Vik also invests and advises startups on growth marketing and product management. Vik's work is focused on themes of marketplaces, micro-entrepreneurship, marketing automation, and user growth. Previously, Vikram led product and growth teams at Overstock.com, focusing on efforts across acquisition, new user experience, churn, and notifications/email. He holds an MBA in Finance from Temple University and a B.S. in Computer Information Systems and Finance from Bemidji State University.