Learn the market cap definition, how it works, and how to use it to inform your investing decisions.
What Is Market Capitalization?
Put simply, stock market capitalization is the amount of money it would cost you to buy every single share of stock a company had issued at the current market price. This metric is useful for comparing the size of one company to another. There are also certain benefits and risks associated with investing in companies of certain sizes, so investors may want to focus on a particular company size, like large-cap companies, or diversify by having small-, mid-, and large-cap companies in their portfolio.
How Market Capitalization Works
Market capitalization includes all available shares in the market. It doesn’t include locked-in shares, like those held by company executives. It’s affected by the value of shares. If company shares decrease in value, a company’s market cap will go down. Exercising warrants can also affect market cap, as warrants increase the number of available shares. A warrant gives you the right to buy a certain number of shares at a specific price in the future. Investors typically base stock investments on potential risk and growth. The size of a company plays a part in its potential for future growth and the risk of it failing. In general, small companies have more potential for growth but are also riskier because they’re unproven. Large companies may not see explosive growth, but they’re also unlikely to fail, even when the economy takes a nosedive.
How to Calculate Stock Market Capitalization
The formula for calculating stock market capitalization is simple. You only need two pieces of data: the number of shares outstanding and the current stock price. Here’s the formula: Market capitalization = Number of current shares outstanding x Current stock market price. For example, on Dec. 31, 2021, The Coca-Cola Company had roughly 4.34 billion shares of stock outstanding, and the stock traded at $59.21 per share. If you wanted to buy every single share of Coca-Cola stock in the world, it would cost you 4,340,000,000 shares x $59.21, or $256,971,400,000. That is more than $256 billion. On Wall Street, people would refer to Coca-Cola’s market capitalization as roughly $256 billion at the end of 2021.
The Benefits of Using Market Cap for Investing
Stock prices can sometimes be misleading when comparing one company to another. On the other hand, stock market capitalization ignores capital structure specifics that can cause the share price of one firm to be higher than another. This allows investors to understand the two companies’ relative sizes. For example, compare Coca-Cola at $59.21 per share with streaming service Netflix at $602.44 per share at closing on Dec. 31, 2021. Despite having an exponentially larger share price, the latter has a stock market capitalization of roughly $267 billion, making it comparable to Coke’s.
The Risks of Using Market Cap for Investing
Stock market capitalization is limited in what it can tell you. The biggest downfall of this particular metric is that it does not factor into consideration a company’s debt. For example, as of December 2021, the company had around $20 billion in current liabilities (debt, taxes, etc.). If you were to buy the entire business, you would be responsible for servicing and repaying all those liabilities. While Coke’s stock market capitalization was $256 billion, its enterprise value was $282.9 billion. All else being equal, the latter figure is what you would need to not only buy all of the common stock but pay off all the company’s debt, too. Enterprise value is a more accurate indicator of determining the takeover value of a company. Another major weakness of using stock market capitalization as a proxy for a company’s performance is that it does not factor in distributions such as spin-offs, split-offs, or dividends, which are extremely important in calculating a concept known as total return. It seems strange to many new investors, but the total return can result in an investor making money, even if the company itself goes bankrupt. For one, you may have collected dividends over the years. The company could also get bought out, and your shares could be bought outright or transferred to shares in the new parent company.
Using Market Capitalization to Build a Portfolio
Many professional investors divide their portfolio by market capitalization size. These investors do this because they believe it allows them to take advantage of the fact that smaller companies have historically grown faster, but larger companies have more stability and pay more in dividends. Here is a breakdown of the type of market capitalization categories you are likely to see referenced when you begin investing.
Small cap: The term small cap refers to a company with a stock market capitalization of $300 million to $3 billion. These are relatively new companies that may have a high level of growth. They’re also more vulnerable to competition and economic conditions.Mid cap: The term mid cap refers to a company with a stock market capitalization of $3 billion to $10 billion. These companies are considered less risky than small-cap companies but riskier than large-cap ones.Large cap: The term large cap refers to a company with a stock market capitalization of $10 billion or more. These are well-established companies that may provide consistent dividend payments and they’re unlikely to swing wildly in price.
