What is Market Cap?
Did you know that as of 2021, Apple is the largest company in the world by market capitalization? After all, it’s one of the most successful companies in the world right now and one of the world’s most valuable stocks.
And while you may not be investing in Apple stock anytime soon, assessing a company’s market cap is an incredibly useful measure to decide whether a company is worth your money.
But what is market cap? And how does it work? Here’s what new investors should know.
What is Market Cap?
For example, let’s say you have a company with 1 million shares, each selling for $100. The company’s market capitalization would ring in at $100 million. For context, Apple’s market cap is an estimated $2.9 trillion.
Market cap is typically used in place of sales numbers or total asset figures to determine a company’s size.
Formula and Calculation
The market cap formula is quite simple:
Market cap = price per share x shares outstanding
Let’s say a company has 1 million outstanding shares, each selling at $20. The company’s market capitalization would be $20 million (1 million x 20).
Sounds simple enough, right? Here’s the catch: the price per stock fluctuates all the time—even from one second to the next. Because of this, market cap also fluctuates wildly. However, while the outstanding shares may increase, this is much more unusual—outstanding shares only increase when the company deliberately creates them through exercise of employee stock options, a secondary offering, a shares repurchase program, or similar actions.
Because of this, market cap changes are almost always attributed to the share price fluctuations.
Market Cap vs. Enterprise Value
Market cap should not be confused with enterprise value, which is not interchangeable even though both are a measurement of the company’s market value.
Market cap is a simple and direct way to calculate a company’s value. From that number, you can infer the company’s growth outlook and risks. Every stock listed on a financial broker’s website will include the up-to-date market cap. Here’s the catch: it only calculates based on price per outstanding share and omits several key facts about the valuation.
Enterprise value is a measure of a company’s total valuation. It includes market capitalization in the calculation but also includes all of the company’s debt obligations. It is calculated as follows:
Enterprise value = (market cap + outstanding preferred stock + debt obligations) – (cash + cash equivalents)
While market cap provides a useful snapshot, enterprise value supplements it by allowing investors to identify potentially undervalued companies.
Types of Market Cap
The types of market cap are broken up by size as follows:
- Nano cap
- Micro cap
- Small cap
- Mid cap
- Large cap
- Mega cap
Nano caps are high-risk, high-reward companies with a market cap of less than $50 million. They’re essentially small businesses and young businesses who haven’t built strong roots in the market yet (and whose returns are much less certain).
At the far end of the spectrum are mega caps, which are companies with a market cap of $20 billion or higher. These are household names and industry leaders on the scale of Apple and Amazon.
Of the bunch, most average investors can afford investments in the range of mid caps to micro caps. However, the smaller and less established the company, the riskier the investment. Micro caps, for example, consist primarily of penny stocks (small company stocks trading at $5 or less per share and do not trade on major exchanges).
Why Market Cap Matters
While you may think a company’s stock price is an accurate measure of the company’s value, it’s an incomplete picture, and it’s not an accurate representation of a company’s value, never mind its stability or overall financial health.
For one thing, a company may have a higher stock price than another company in its industry but still have a lower market cap. You won’t know how the price translates into actual value without looking at the market cap.
For another, understanding a company’s value lets you know how much capital the company might have available to invest. A multi-billion-dollar company can easily afford to spend a few million on research and development for a new product line, but a mid-cap company could be driven to failure if the exact same investment failed solely because they don’t have the capital to cushion the blow.
Limitations of Market Cap
That said, you should always keep in mind that market cap is based on the company’s stock price. Remember, investors are the ones who determine stock price by demonstrating how much they’re willing to pay for a given security.
Because of that, market cap is not the company’s exact value. It’s the company’s perceived value in the eyes of investors. There may be a significant gap between the market cap and what the company is actually worth. This can happen for several reasons, like optimistic growth expectations, but those expectations may or may not translate into reality.
As such, you should never rely on market cap as your sole determinant of investment strength. You should always look at the number in tandem with several other value metrics to assess the company’s overall health and performance and whether they’re the right fit for your financial goals.
Invest for Success Beyond Market Caps
As an investor, you have to be smart about where you put your money. Market cap is just one of the many ways you can figure out if a company is worth your investment.
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