Market capitalization is extensively talked about. But, how much do you know about it?
In the financial world, many investment options exist to cater to all types of consumers. Some stock is secure while others come with high risk and volatility. Depending on confidence levels, users can choose to go for large well-established companies or head to the innovators and game-changers.
Thus, the market value of a company, market cap, could be a great start for the basis of any investment decision made.
Market Capitalization Description
Also known as market cap, it is a multiple of all the company’s shares outstanding by the current market price for each share. It acts as a reliable metric to get the total market value of any given company. It tells the amount of money needed to buy all the company’s stock circulating on the market.
Investors also use the market cap as a primary determinant for the company’s size and assists in comparing a company versus another especially a competitor. Market cap is different from the free-float market cap. While market cap incorporates all the shares circulating on the market, the free-float market cap focuses on just the outstanding shares accessible for the general public.
Thus, free-flat excludes the locked-in shares reserved by the company governance or executives. Major indexes like Dow Jones Industrial Average and S&P 500 use the free-float market cap. It proves useful since it offers a realistic estimate and assists in the formation of a more accurate representation of the company’s market worth.
Market Capitalization Debunked
Market cap is straightforward to calculate if the two variables which include the price of one share and the number of outstanding shares are known. For instance, if Company A has a total of 50,000 shares outstanding and each trade at $8, then the market cap will be the multiple of the two variables which is $400,000.
Thus, the market cap applies more to public companies than their private counterparts. The price of the stock of the public companies is settled by the stock exchange reflecting the value on the market. For the private firms, no clear price estimate is available though there are different approaches to value the company.
The most common approach is to compare the private company with a public one that closely resembles it. Other methods of valuation include equity valuation metrics like price-to-free cash flow, price-to-book, price-to-earnings, and price-to-sales. All these alternatives come together with estimating discounted cash flow.
Market capitalization is important since it tells the company’s size which is also used as a benchmark for comparing companies. Also, it brings out the knowledge of the perception of a company by investors because the stock price reflects the amount of money that the investors are willing to pay. The amount of money investors are willing to pay shows how much confidence they have in a given company.
Factors That Impact Market Capitalization
Several factors, both external and internal, are known to impact the market cap of any company. These include:
- The issue of dividends – though a stock’s price may rise due to dividend payments, it may affect the share’s price in the opposite direction. A company increases the number of outstanding shares when issuing dividends which delude the value per share and causes the stock price to plunge.
- Change in share value – If for some reason the share price changes in any direction, the market cap is the first one to change. Such changes come when a company makes major important announcements that may affect the course of work. They may also get provoked by the external macroeconomic situations.
- Share Splits – If a company splits shares 2 for 1, their number doubles. Thus, the stock goes down because with more shares on the market having the same cumulative value, the price per share will invariably get halved.
- An increasing number of shares outstanding – whenever a company decides to pump more shares into circulation, the price per share plummets. That happens since the company’s market value is unchanged in the short term. But, some changes may arise in the long term.
Market Capitalization by Size
Investors use the market cap to estimate the size of the individual players to get a better feeling of the market environment. Three types of companies exist in terms of market capitalization.
- Small-cap companies – these have up to $2 billion in capitalization and they mainly include the newly established firms that possess future growth potential. Also, some businesses that were successful in the past but lost their share value significantly fall in this category as well. These companies show the attractive future potential that comes with high risks.
- Mid-cap companies – these have a market cap ranging between $2 billion and $10 billion. They have more volatile stock compared to the large-cap companies. But, it is all cut down by high growth potential that is reflected in the stock. Mid-cap companies may not be the market leaders but they are on their way to joining the leaders. Recent studies show that the mid-cap outperforms the large-cap and small-cap companies within the past 20 years.
- Large-cap companies – they have more than $10 billion in market cap and they are considered among the safest investment options because they are least exposed to financial risks. Also, they are most likely to pay dividends. Nonetheless, the return on these large-cap companies may not be the same as that on the more risky stock.
To build a stable financial portfolio, investors should apply a mix of all the above-mentioned types. That strategy reduces risks and improves returns eventually helping investors to achieve their financial goals. But, for all that to work out, an investor must start by defining their financial goals, establish time horizon, and evaluate risk tolerance. Then and only then will they have the ability to pick up a proper mix of market caps.
Myths about Market Capitalization
The definition explains that the market cap shows the company’s monetary value on the open market. Moreover, it shows the investors’ expectations based on the share price. The more they are ready to pay, the higher the share price becomes and vice versa. However, does the mark cap indicate the real value of a company?
No straightforward answer exists but the worthiness of a company could be much more complex to define than its value shown on paper. Notably, the market cap is the amount of money an investor may need to pay if they want to acquire the firm in a single transaction.
But, the market cap does not tell about the company’s internal situation. On the contrary, it represents the value that other people on the market assign it. The real value of a company is much cumbersome to assess. To get a viable solution, investors base their choices on fundamental analysis like return-on-equity and price-to-earnings.
Corporate debt, interest rates, and long-term growth potential are also considered and play a major role while deciding the company that one should invest in. These factors offer an extensive overview compared to just market cap that changes due to pressure of recession or bear market. It is also normal for a company to sometimes get overvalued or undervalued on the market.
In the case of overvaluing, a good investor sells the stock while undervaluing presents great opportunities to buy the stock. But that cannot be told from just market cap but rather from fundamental analysis.
Therefore, the market cap may be the quickest method of getting a snapshot of a company’s position on the market. But, it is inadequate to make the center of your financial decision.
Market cap is a valuable metric that assists investors to know the worth of a given company on the market at any given time. Understanding this factor may help an investor to benchmark the company against other similar companies on the market. Popular market indexes like NASDAQ are including market capitalization. they are using it as a strategy of measuring a company’s size and importance on the market.
But, the market cap should get implemented keenly in financial decisions and not overestimated because it tells something tangible about the market perception of any given company instead of its true value.