Understanding Market Capitalization, its Meaning and Formula

Market capitalization is an oft-used term in the financial market. And, it is one of the most important terms that you must understand if you want to understand share market and stock performance. It is one of the important elements that help you make your investment decisions. In this write-up, we are providing all the important details about the term market capitalization.

What is Market Capitalization?

Market capitalization, commonly known as market cap, refers to the total market value of shares of a company. In other words, market capitalization is the worth of a company as determined by the share market. This value is used for determining the size of a company in the market. The greater the market capitalization the better the company is supposed to be placed in the market.

The value of of market cap is arrived at by multiplying the total number of outstanding shares with the current market price of that share. The term outstanding share here refers to the total number of shares available in the market and with the investors.

Formula of Market Capitalization

The market cap of a company can be computed using the following formula:

Market cap = share price x number of outstanding shares

Let us understand this with an example. Suppose a company has a total of 10 million outstanding shares in the market. And, the shares are currently priced at USD 100 each. Then the market capitalization will be USD 1 billion (10 million x 100)

Types of Companies based on Market Capitalization

You already know that the companies are divided into certain categories based on different determinants like sales, operation, ownership, etc. Similarly, companies are also categorized based on their market capitalization.

Large Cap

Large-cap companies, as evident by the name, are companies with large market capitalization. A company is considered large-cap when it values roughly above USD 10 billion.

For investment purposes, large-cap companies are considered a safer investment as this category generally represents a more established company that has a long history of performance. Companies under this category do not provide huge returns in the short term but they are the best choice for those who hold the shares for a longer period. They are known for their consistent and stable growth. Some of the large cap companies are bestowed with the tag of ‘blue chip companies‘ for being financially strong, stable, well-established, and recognized.

Mid Cap

A mid-cap company is a company that is neither too big nor too small based on its market capitalization. Mid cap companies roughly fall between USD 2 billion and USD 10 billion.

For investment purposes, mid-cap companies are considered good for investors with little higher risk appetite for a rapid growth rate. This category consists of companies that are yet not as stable as large-cap companies but has a promising future as they are in the process of expansion.

Small Cap

Small-cap companies are the companies with the smallest share in the stock market. Small cap companies are registered on the share market with a market value hovering between USD 300 million and USD 2 billion.

For an investor, small-cap companies provide higher growth potential but at an equally higher risk quotient. An investment in a small cap company may turn multi-bagger over a few years but it may also eat up a person’s invested principle amount. The share prices of these companies are more volatile and less liquid as compared to the bigger companies.

Micro Cap

Companies with very small market capitalization are termed micro-cap companies. This includes companies ranging between $ 50 million and $ 300 million.

Typically, shares of companies falling under the micro-cap category are called penny stocks. These penny stocks are considered to be extremely risky for investment purposes.

Usage of Market Capitalization

You may wonder, why in the first place we calculate the market capitalization value of a company. So, let us explore the usage of market capitalization. After all, we must not be calculating this huge value just for the sake of it. There has to be a solid reason behind it.

• Estimating a Company’s Value – It is important for us to understand a company’s value. Calculating market capitalization is a quick and reliable way of determining the value of a company. We arrive at it by simply multiplying the current market price with the number of shares in the market. It gives us the true picture of people’s trust in the business and operation of the company.
• Calculating Risk Factor for Investors – Market capitalization is an important metric for assessing risk factors before investing in a company. It helps the investors categorize companies based on their total market share and determine the risk factors associated with them. Though there are other ways of calculating risk factors, market capitalization is very simple yet effective.

Limitation of Market Capitalization

Market Capitalization is undoubtedly a useful metric for investors. But, it should not be seen as the only indicator of a company’s health. The biggest limitation of market capitalization is that it narrates only the half story. This metric tells about the value the general public or investors attach to a company. Value of market cap does not reflect the true picture of the company’s actual performance.

Although many institutional and non-institutional investors take the fundamentals of a company into account while deciding the worth of a company, the current market price is not the true reflection of the company’s present operating condition. Further, the fundamental information like balance sheets and other financial statements taken into consideration by investors are historical in nature i.e. they show a company’s past performance rather than the current position.

Market capitalization is basically the valuation of the trust of investors in the company. Though trust is a strong intangible asset for a business, the market cap is not the true representation of the overall position and valuation of a company.