Long-term investors try to understand the relationship among company revenue,risk and potential returns in order to balance their stock portfolios. Marketcapitalization (market cap) is a key figure they use when deciding whether toinvest in a particular company because it makes it easy to compare businesses ofsimilar size in the same industry.
For companies considering an initial public offering (IPO), it's importanttounderstand market cap because analyzing comparable companies is one of severalfactors used to determine IPO valuation.
What Is Market Capitalization?
Market cap represents the market value of a company based on its current shareprice and the total number of its outstanding shares. Market cap provides aconvenient way to track and compare publicly traded companies based on theirvaluation. Comparing the market caps of similar companies and help investorsdecide whether a given company is overvalued, valued correctly or undervalued bythe market.
There are three primary market cap categories: large-cap, for companies valued at$10 billion or more; mid-cap, for companies valued between $2 billion and $10billion; and small-cap, for companies valued roughly from $300 million to $2billion. These market cap sizes have traditionally also corresponded to acompany's stage of development, but nowadays this is far less true.Especiallyfor companies in industries such as information technology and biotechnology,there is a growing incidence of high valuations that are out-of-proportion tothe company's maturity.
Because a company's market cap is determined by its share price, it representsinvestors' perceived value of a business, rather than its book value. Itrevealshow much investors are willing to pay for the company's stock and, as such,thecompany's susceptibility to economic headwinds is "priced in.”
Still, market cap doesn't tell the whole story of a company's value.Companieswith similar market caps may have different price-to-earnings (P/E) ratios, aswell as dissimilar levels of outstanding debt or authorized shares that have notyet been sold to the public. Market cap also leaves out considerations likepresent and future cash flow and the resale value of company assets. A companywith a market cap much lower than its resale value could be a target for atakeover.
In general, the higher a company's market cap, the more it can benefit fromgreater coverage by stock analysts and more access to loans for reinvestment.The higher the valuation, the more likely the business has capital to deploy andinvest in future growth.
Key Takeaways
- Market cap is a measure of value used to analyze and compare similar stocks.
- Market cap is simply the total value of all of a company's outstandingshares, so it reveals how much investors are willing to pay for a stock.
- Mutual fund portfolio managers and other investors use market cap as astandard way to categorize investments and compare the performance ofsimilar investments.
- Market caps are classified by size/dollar value (small, medium and large),which historically has corresponded to a company's stage ofdevelopment. Butthis relationship has decreased over time.
- For companies that are preparing to go public, understanding market cap canhelp them estimate the amount of capital they might be able to raise.
Market Cap Explained
Market cap is one of many measures investors use to evaluate the size of acompany and where it is in its development. Businesses also use market cap toassess targets for their acquisition and partnering strategies and as a factorin their own investment planning. Stock indexes and investment funds groupcompanies together by market cap for comparison purposes and to provideinvestors with options for portfolio investment strategies. Market cap isparticularly helpful for diversifying investment portfolios to reduce the impactof a decline in one market cap category. For example, last year the Dow JonesU.S. Large-Cap Growth Total Stock Market Index was down 30.88% year-to-date(YTD) as of late October 2022, while its small-cap counterpart was down only23.58% — a significant difference for investors.
Many factors can influence a company's market cap, including changes insharevalue, the number of shares issued or an exercise of warrants that increases thenumber of outstanding shares. Stock splits or the issuance of dividends do nottypically alter a market cap since, in both cases, the increase in sharesoffered is accompanied by a price drop. For example, in the case of a 2-for-1stock split, the share price is halved.
Importantly, market cap doesn't necessarily reflect how much a business isactually worth because it doesn't account for certain crucial factors, suchas acompany's cash reserves or debt. Another calculation, called "enterprisevalue," better represents the total value of a company and isdefined asits market cap plus outstanding debt minus available cash. Enterprise value isused to calculate the potential cost to acquire a company and to compare therelative performance of different companies.
How to Calculate Market Cap
Market capitalization is calculated by multiplying the number of a company'soutstanding shares times the current market value of one share. The formula is:
Market cap =price per share x shares outstanding
For example, a company with 30 million shares currently selling at $100 per sharehas a market cap of $3 billion, while another company with 20,000 shares sellingat $1,000 per share has a market cap of $20 million. If you looked only at theirper-share prices, you wouldn't know the first company was the more highly valuedof the two. Investors often consider companies with larger market caps to besafer investments over the long run.
Free-Float Market Cap
Another way to calculate market cap, called the free-float method, excludesshares not freely traded on the public market because they are locked in bycompany executives, pledged as collateral to lenders, held by trusts or privateequity funds or any other reason. Market caps calculated using the free-floatmethod are always less than those calculated with the basic formula, and manyindexes have adopted it. The formula is:
Free-float market cap= price per share x (shares outstanding – locked shares)
How to Use Market Cap
Investors use market cap as a quick way to evaluate a company's size and therisk/reward of owning its stock. Businesses can use market cap as a first stepin assessing the affordability of an acquisition target or a capital infusion tofund growth. Leaders of public companies keep a close eye on any change thatcould impact market cap. Both internal changes, like a management shift orlayoffs, and external events, like earnings reports or lawsuits, can cause shareprices and, therefore, market cap, to shift.
Asset management companies use market cap as one of the standard ways theycategorize investment offerings. Mutual fund portfolio managers and investmentadvisers may have proprietary guidelines for categorizing companies by marketcapitalization. The popular Standard and Poor's (S&P) indexes forlarge-caps, mid-caps and small-caps, for example, consider stock market value,financial performance, business sector and historical factors in categorizingthe companies for its indexes. One reason they do this is that market captypically aligns with other factors. Large-cap stocks are generally consideredlower risk with less aggressive growth potential than small-cap stocks, whichare considered higher risk with more growth potential. Mid-cap stocks generallyfall in the middle on the risk/return spectrum. In recent years, however,increasing exceptions to this historical guideline have muddied the waters.
Market cap is also used to target stock purchases to specific investment goals.Investors looking for rapid growth may focus on promising small-cap stocks,while those looking for consistent dividend payments might lean toward large-capstocks. And because each market cap category has historically reacteddifferently to market andeconomicconditions, many investors diversify their investment portfolios tomaintain a mix of market caps that fit their financial goals and risk tolerance.
Market Cap Categories
From the largest to the smallest, market capitalization gives business managersand investors a snapshot to help them compare the relative sizes of companies.The different market cap categories come with some rule-of-thumb assumptionsregarding the maturity of a company, how much capital it can deploy and itsrisk-versus-return potential.
Mega-cap
At the extreme ends of the market-value spectrum you'll find the largest andsmallest companies that are traded on the major indices. Mega-cap companies havea market value over $200 billion. While there are only a handful of corporationsthis size, they make up approximately 20% of the S&P 500 Index for large-capstocks. Mega-cap stocks include companies like Apple Inc., Microsoft Corp.,Amazon Inc. and Facebook Inc.
Large-cap
Large-cap stocks are those with market valuations of more than $10 billion. Whenthe categories came into use, companies with large market caps were typicallywell-established and in more mature industries but, today, younger companiesthat investors believe have high growth potential sometimes run up intolarge-cap territory. In general, though, large-cap stocks are supposed todeliver a consistent return on investment with less risk than smaller stocks butwith only moderate growth prospects. Large-caps include the best-known brands inthe world and are leaders in their industries. They tend to generate more cashthan they need to run their businesses and return that extra capital toshareholders as dividend payments. They are considered a safer long-terminvestment than smaller-cap companies and tend to outperform small caps in downmarkets — which is one reason why the better performance of the Dow JonesSmall-Cap Index mentioned above relative to its sibling large-cap index madenews.
Mid-cap
Mid-cap stocks are those with market valuations between $2 billion and $10billion. Companies in this range are typically in industries experiencing orexpected to experience growth. They have a track record of increasing theirmarket share and improving their competitive position but may still face futurechallenges trying to disrupt better-funded large-cap competitors or fighting offcompetition from other mid-caps and promising upstarts. Mid-caps might befast-growing companies that have outgrown their small-cap status or formerlarge-cap companies that were disrupted and have since declined in theirmarkets. Mid-caps may offer more growth potential than large caps and possiblyless volatility than small caps.
Small-cap
Small-cap companies are those with market valuations between $300 million and $2billion. Companies with smaller market caps are usually considered growth stocksand are typically younger companies in newer industries or niche players ingrowing industries with higher risk but attractive growth potential.Historically, small-cap stocks have delivered above-average returns over time,but they are generally owned as a group to reduce risk because, individually,they tend to have more dramatic value fluctuations. Small-cap stocks arehistorically more susceptible to industry andeconomicdownturns and tend to underperform during "bear markets" andoutperformin "bull markets," although that was not the case in 2022.
Micro-cap
Micro-caps are businesses with market valuations of $50 million to $300 million.Also known as "penny stocks," micro-cap businesses have often gonepublic withnew products or services. They are highly speculative but can have a hugeupside.
A Quick Breakdown of Standard Market CapCategories
| Market Value | Typical Company | Risk/Reward Potential | |
| Mega-cap | Over $200 billion | Major global brands, market leaders | Trusted to deliver steady dividends and returns |
| Large-cap | $10 billion or more | Major players in well-established industries | Low risk, consistent increase in value over time |
| Mid-cap | $2 billion to $10 billion | Established companies in growing industries | Attractive growth potential but higher risk |
| Small-cap | $300 million to $2 billion | Younger or niche companies in newer industries | More volatile, higher risk, high growth potential |
| Micro-cap | $50 million to $300 million | Newer companies with unproven products and little history | Greater volatility and inherently riskier but can performin bull markets |
Fully Diluted Market Cap Formula
Sometimes companies authorize more shares than they have issued. This happens,for example, when employees have options to buy stock from the company at acertain price at a certain time or when companies issue securities or debt thatcan be converted into shares of stock. If the difference between outstanding andauthorized shares is large enough, then the number of outstanding shares mightrise quickly when such options are exercised, driving down the price of existingshares. In this case, investors can use the diluted market cap formula tocalculate what the potential market cap would be if all stock options wereexercised and all convertible securities were exchanged for stock. A fullydiluted market cap is calculated by multiplying the current share price timesthe total number of shares authorized, or:
Fully diluted marketcap = price per share x shares authorized
For instance, a company with 20 million outstanding shares at $10 a share couldalso have convertible securities eligible to be exchanged for another millionshares. In that case, the company's market cap of $200 million wouldtranslateto a fully diluted market cap of $210 million. It's important to note thatafully diluted market cap is merely a projection of what could happen. Shareprices may rise or fall before the event, and the event itself, by increasingthe supply of outstanding shares, could cause the price per share to fall.
Market Caps for Cryptocurrencies
The diluted market cap formula is prevalent in securities where market capschange frequently over time. Cryptocurrency is a prime example. Cryptocurrencieslike bitcoin are virtual coins, not shares, but the market capitalizationconcept remains the same. You can calculate a coin's market cap bymultiplyingall circulating coins by the price of each one.
Cryptocurrency, however, is issued frequently and typically exhibits greaterprice volatility than stocks, so a coin's market cap will also fluctuaterapidly. And as new coins enter the market, they theoretically reduce the valueof existing coins, so the standard market cap formula will not accuratelycalculate the potential market cap. Therefore, analysts and investors usediluted market cap to understand potential changes to the price of a security,token or coin. And companies that maintain larger inventories of securities orcrypto coins are at greater risk of price decreases.
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Market capitalization is a useful and widely used measure that gives investorsand business managers an immediate sense of the size of a company. Market cap isincorporated into several deeper business metrics that attempt to assess acompany's financial performance and future prospects, such as enterprisevaluecalculations. For midsize companies considering public market entry, betterunderstanding market cap and related metrics can help them estimate how muchcapital they might raise.
Market Cap FAQs
What could impact a company's market cap?
A broad range of factors inside and outside a company's control can affectit*market capitalization — essentially, anything that influences stock marketprices. This is because market cap is simply the price of one share of acompany's stock times the number of that company's outstanding shares.If themarket is trending up or down, a company's stock is likely to rise or fallalongwith that trend, affecting its market cap. Factors specific to the company arelikely to have a more pronounced impact on its market cap, especially thecompany's business performance as reported in quarterly financialstatements.Stock buybacks and new share issuance can also impact market caps because theychange the number of shares outstanding.
What are large-cap stocks?
Large-cap stocks are those with market capitalizations of $10 billion or more.When a company's market cap rises above $200 billion, it's consideredamega-cap.
What makes market capitalization change?
Market capitalization is calculated as the number of outstanding shares of acompany's stock times the price of a single share. Therefore, any changesinshare price or outstanding shares (such as a stock buyback, employees exercisingstock options or lenders exercising options to convert debt into shares) willcause market cap to change.
Market cap vs. free-float market cap: What's thedifference?
Market capitalization is calculated by multiplying the number of a company'soutstanding shares times the current market value of one share. Free-floatmarket capitalization excludes shares not freely traded on the public market(such as those locked in by company executives) and is always less than marketcap calculated with the basic formula. To calculate free-float market cap,subtract the number of locked shares from the number ofshares outstanding and then multiply the answer by price per share.
Why is market cap important?
Market cap is used by investors and business managers to evaluate acompany'ssize and usually also corresponds to a company's stage in businessdevelopment.Understanding the relationship between company size, return potential and riskis crucial for investors creating a long-term investment strategy.
Is a high market cap good?
Companies with large market caps ($10 billion or more) are generally consideredmore conservative investments than small-cap or mid-cap stocks, the theory beingthat they pose less risk in exchange for less growth potential. The higher thevaluation, the more likely the business has capital to deploy or invest infuture growth. A higher market cap also tends to attract more analyst and presscoverage and means better access to loans for reinvestment.
What is a good market cap?
The answer is … it depends. For investors, a good market cap is determined bytheir investment goals. While large market caps typically represent stability,smaller market caps have more room to grow. Investors typically build stockportfolios with a mix of market caps to offset any declines in the value of onemarket cap category.
What does it mean if market cap is high?
A high market cap usually indicates a more mature company with market valuationsof more than $10 billion. Large-cap stocks are usually considered to be saferinvestments than mid-cap or small-cap stocks but typically have more moderategrowth prospects.
