The valuation of companies is a critical component of investment analysis and a vital determinant of a business’s financial well-being. Investors must thoroughly understand a company’s value to make informed investment decisions in the dynamic and ever-changing stock market.
One of the most widely adopted metrics for evaluating the value of a company and its growth potential is market capitalization, often called “market cap.”
Below, you’ll learn how to calculate market cap, understand its use in business and learn a comprehensive and intellectually rigorous explanation of its significance in valuing companies.
How do you calculate market cap?
Market cap is a foundational metric in evaluating a company’s financial stability and growth prospects.
Market cap is calculated by multiplying a company’s current share price by the number of its outstanding shares.
This calculation yields a dollar amount that represents the total value of the company’s stock on the market and serves as a critical indicator of the company’s size, stability, volatility and growth prospects.
For example, let’s consider a fictional company, ABC Inc. As of March 1, 2023, ABC Inc.’s current share price is $30 and the company’s outstanding shares are 100 million. By multiplying the current share price of $30 by the number of outstanding shares, which is 100 million, one obtains a market cap of $3 billion.
This figure provides valuable insight into the growth prospects of ABC Inc. as a company. For instance, with a market cap of $3 billion, ABC Inc. is considered a mid-cap company and stock, as its market cap falls between $2 billion and $10 billion.
Why is market capitalization important?
Understanding market capitalization allows you to perform various financial tasks accurately.
Some of these include:
Assess the company’s size and investment potential
A company’s market cap indicates its size and investment potential. For instance, a mid-cap company like ABC Inc. has a moderate level of size and growth potential.
Determine the company’s stability and volatility
The market cap also indicates its stability and volatility. Generally, mid-cap companies are considered less volatile than small-cap or micro-cap companies but more volatile than large-cap companies. The same difference applies to small-cap stocks and large-cap stocks.
Market cap is a crucial metric for investors when making informed investment decisions. Specifically, comparing market cap between different companies allows for the assessment of the relative size and investment potential of these entities.
For example, a smaller company might have more upside potential but may be riskier due to its size and less established track record. On the other hand, a larger company may be more stable and have a proven track record but may have less room for growth. Ultimately, investors must weigh these factors carefully when choosing where to invest their money.
What are the different market cap designations?
Market capitalization designations offer a valuable framework for evaluating companies’ relative magnitude and investment prospects. The following are the most fundamental categories:
1. Large-cap companies and equities
A market capitalization above $10 billion categorizes a company or equity as large-cap. These organizations exhibit a high degree of stability and comparatively low levels of volatility, making them suitable for investors seeking stability in their portfolios.
2. Mid-cap companies and equities
As discussed in the previous example, companies and equities with a market capitalization between $2 billion and $10 billion are classified as mid-cap. Mid-cap companies balance stability and growth potential, making them appropriate investments for those seeking stability and growth.
3. Small-cap companies and equities
Organizations and equities with a market capitalization below $2 billion are deemed small-cap. These entities possess substantial growth potential but are also associated with higher levels of volatility.
As a result, small-cap companies may be suitable investments for those willing to tolerate elevated risk levels in pursuit of higher returns.
4. Micro-cap and mega-cap companies and equities
Companies and equities with a market capitalization below $50 million are designated micro-cap, while those with a market capitalization above $200 billion are designated mega-cap.
These designations represent the smallest and largest companies and may be appropriate investments for those seeking exposure to niche or highly established markets.
How does market cap influence investment analysis?
Market capitalization is also a critical component of investment analysis, offering more granular insights into a company’s health and standing.
For example, in the realm of investment analysis, individuals use market caps to:
1. Evaluate capital structure
The market cap provides a comprehensive view of a company’s capital structure. Capital structure refers to how a company finances its assets, operations and growth through debt and equity.
In simpler terms, it’s the combination of loans and bonds a company takes on and the money it raises through issuing stocks. The optimal capital structure balances the benefits of debt financing, such as lower costs and tax benefits, with the risks of increased financial leverage.
2. Analyze investment metrics
Market cap is also relevant in analyzing investment metrics, including earnings growth, profitability and dividend yield. Profitability metrics, such as return on investment (ROI) and return on equity (ROE), measure a company’s ability to generate profits and return value to its shareholders.
Investment professionals may consider a company’s market capitalization with its profitability metrics to understand its financial stability and investment potential better.
3. Market cap and industry analysis
Market cap is useful for analyzing industry trends and the competitive landscape. Investment professionals can use market capitalization to assess companies’ relative size and market share within a specific industry, providing valuable insight into the industry’s competitive dynamics and growth potential.
By tracking changes in market cap over time, investment professionals can identify emerging trends, shifts in market share and changes in a company’s competitiveness.
Related: Return on Investment (ROI)
What does market capitalization look like in public company analysis?
High-profile companies like Microsoft, Apple and Amazon illustrate market capitalization’s impact on investment decisions. Throughout each company’s lifespan, market downturns, stock splits and changes in free-float market capitalizations have added dynamism to overall performance.
A company’s past performance is closely correlated with market capitalization. By analyzing changes in a firm’s market capitalization over time, investors can comprehensively understand its historical financial stability, growth prospects and risk exposure.
In addition, market caps are also relevant in analyzing market downturns and economic volatility, as fluctuations in market capitalization can provide insights into a company’s resilience and potential for recovery.
Stock splits represent a fundamental change in a company’s capital structure and can significantly impact its market capitalization.
By altering the number of outstanding shares, stock splits can affect a firm’s market value, making it essential for investors to carefully consider the impact of these changes on the financial stability and growth prospects of the company.
Finally, free-float market capitalization is an essential metric for investment analysis, as it provides a more accurate representation of a company’s market value by excluding restricted shares of stock held by insiders or other stakeholders.
By considering free-float market capitalization, investors can make informed investment decisions based on a more precise evaluation of the market value of a company.
What role does market capitalization play in evaluating the value of cryptocurrency?
In recent years, the cryptocurrency market has become an increasingly important and dynamic arena for investment, with market capitalization serving as a critical metric for evaluating the value of different cryptocurrencies.
Calculating the market cap of a cryptocurrency is identical to calculating the market capitalization of any other asset — multiply its current market price by its circulating supply.
Cryptocurrency market caps can vary drastically, with some cryptocurrencies commanding relatively small market caps of a few million dollars. In contrast, others boast market caps of hundreds of billions of dollars.
This variation in market cap is due mainly to differences in the underlying technology, adoption rate and overall market demand for each cryptocurrency.
For example, Bitcoin, the largest cryptocurrency by market cap, has a current market cap of just shy of $500 billion, reflecting its widespread adoption and strong demand from investors.
On the other hand, Ethereum, the second largest cryptocurrency by market cap, has a market cap of around $200 billion, reflecting its growing popularity as a platform for decentralized applications and smart contracts.
In addition to market cap, investors in the cryptocurrency market also pay close attention to other metrics, such as trading volume and adoption rate, as they make investment decisions.
While the market cap of a cryptocurrency can provide a useful starting point for evaluating its overall value and potential for growth, much like in traditional investing, it’s just one of many factors that investors consider as they assess the risks and opportunities in the market.
How does liquidity interact with market capitalization?
Liquidity is a crucial factor in investment analysis, representing a company’s ability to meet its financial obligations and respond to market demands.
In market capitalization, liquidity is often considered in terms of a company’s free float market capitalization. As discussed, it represents the portion of a company’s market cap available for trading and is subject to market fluctuations. This metric is closely tied to liquidity as it provides insight into the ease of buying and selling shares.
An analysis of a company’s market capitalization, particularly its free float market capitalization, can provide valuable information about the liquidity of its shares and the potential for buying and selling activities to impact the company’s stock price.
This information can be vital for short-term investors seeking to enter quickly or exit positions or for long-term investors evaluating the stability and sustainability of a company’s financial position.
What can understanding market caps do for your business?
Market capitalization is essential in evaluating a company’s financial health, growth prospects and investment potential. By also providing insights into a company’s size, stability and volatility, market cap enables investors to make informed and strategic investment decisions.
Furthermore, market capitalization is a vital component of investment analysis, offering a comprehensive view of a company’s capital structure, investment metrics and trends.
Moreover, in cryptocurrency, market capitalization serves as a critical metric for evaluating the value and potential of different cryptocurrencies.
While market cap is just one of many factors investors consider, it provides a valuable starting point for assessing the health and potential of various cryptocurrencies.
Overall, keeping track of market capitalization and understanding its significance is crucial for investors to make well-informed and potentially lucrative investment decisions in the fast-paced and ever-evolving financial landscape.
Explore Entrepreneur’s vast collection of articles for more information on other critical aspects of financial management.