So we've all heard some version of: “Amazon is the most valuable company in the world!” But what does that mean? Is value a measure of profit? Are they referring to the value of Amazon’s assets, or maybe the number of people they employ?
What they're really saying is: Amazon has the highest market capitalization in the world.
Market capitalization — or 'market cap,' as the pros say — is an important investment metric that every investor should understand. Understanding what this term means and what it exactly it measures will help you make better informed decisions about your stock choices and, most importantly, diversify your portfolio to counteract risk.
What is Market Capitalization?
Market cap refers to the total dollar value of a company’s outstanding shares, which includes all shares owned by stockholders, public investors, and company officials. (It doesn't include shares the company purchased back.) It's a reasonable way to gauge the value of a stock.
Other metrics to measure a company's value just aren't as valuable. You don't want to value a company based on sales because those can be creatively reported and don't tell you how much profit a company earns. You don't want to value a company based on total assets (the things it owns) because owning a lot of things doesn't necessarily indicate profit. A trucking company, for example, might need more equipment to do business than a software company, but the software company could still be worth more.
Companies are typically grouped into one of five tiers based on their market caps:
1. Mega cap
This group includes companies that have a market cap of $300 billion or more. These are the biggest publicly traded companies in the world. They’re usually leaders in their industry or sector. Naturally, this is a small group because few companies reach this size.
As of December 2018, there are only 25 mega cap companies, which include Apple, Amazon, Boeing, Bank of America, Facebook, Google, and other big names you’ve probably heard.
2. Large Cap
This group includes companies with a market cap between $10 and $300 billion. Like mega cap companies, large cap companies are considered relatively stable and secure investments. They’re called “blue chips,” a term that comes from poker.
Keep in mind, however, that just because a company is large doesn't mean it's safe to invest in. There is always an element of risk when you buy stocks. For instance, General Electric is a large cap company that had a market cap of $260 billion in January 2017. But in October 2019, it was only worth $75 billion. It’s still a large cap company, but that’s a big decline in just two years.
3. Mid Cap
Mid cap companies have market caps between $10 million and $2 billion. They’re more volatile than large and mega cap companies, but generally sustainable. They operate in industries that are expected to grow.
4. Small Cap
Small caps have market caps between $300 million and $2 billion. They’re mostly young companies with high growth potential, or companies who serve new and niche industries. Some are older businesses that have declined.
5. Micro Cap
This category includes companies with market caps between $50 million and $300 million. These companies are considered “penny stocks” because their shares are worth less than a $5. They are not a good choice for faint-of-heart investors.
Market cap categorizations are often the basis for market indexes. The S&P 500, for instance, is an index of 500 companies with the largest market caps. The FTSE 100 indexes the top 100 companies with the highest market capitalization on the London Stock Exchange. These kinds of indexes are used to represent the market’s overall health and the performance of various funds and portfolios.
Market Capitalization Formula
Market cap is relatively easy to calculate. You simply multiply a company’s outstanding shares by the current market price of one share. “Outstanding shares” refers to the total number of stock held by the company’s shareholders, including shares held by institutional investors (private funds) and restricted shares held by the company’s officers.
Since there are only two variables here, a change to either or both can increase or decrease a company’s market cap. Small changes to the price of stock (up or down) are completely normal and don’t mean much to investors. Significant changes to the price, however, can make investors nervous and anxious to sell.
A company can affect their own market cap by issuing or repurchasing shares. For example, if Acme Inc. has 20 million shares and decides to issue another 10 million, the company’s market cap would fall by 33%.
A stock split does not affect the company’s market cap because even though the company generates more shares, the shares themselves fall in value. For example, after a 2-for-1 split, a company would have twice as many shares, each at half the value, so the total market cap is the same.
How to Calculate Market Capitalization
Let’s use an example to calculate market cap.
Globex Corporation has 25 million outstanding shares. Shares trade at $32.
(25 million shares) x ($32/share) = $800 million market cap.
If the share price increases to $35 tomorrow, Globex’s market cap will rise to $875 million. If the share price falls to $28, the company’s market cap falls to $700 million.
Thankfully the wonder of modern technology means that we don't need to whip out a calculator to figure out the market cap of a company. Many financial websites provide this information for numerous equities and ETFs.
Benefits and Drawbacks of Market Capitalization
Market cap is a key tool to evaluate the risk of owning shares in a company and the growth potential of your investment.
Companies with large market caps are generally older businesses with secure positions. A bad year or two usually won’t tear them down. They typically have access to financing for expansion.
The downside to a large market cap, however, is that there’s usually less room to grow. Microsoft, for instance, is such a dominant force that it struggles every year to find new ways to make more money, and often has to create new products and dive into new verticals.
Companies with smaller market caps are typically younger and riskier. They aren’t considered fixtures in their industry, often have inexperienced leadership, and they’re vulnerable to big blows if their product or service doesn’t pan out.
This doesn’t mean that a company with a small market cap is bad for investors. Smaller companies have a lot of room to grow, which means your investment in them could be quite profitable.
Why We Need Market Cap
We need market cap to help us understand how much a company is worth because share price doesn’t paint the best picture.
You might assume that a higher share price indicates a larger, healthier company, but that isn’t always the case. Nor does a low stock price indicate that you can buy shares at a bargain. It’s quite possible for a company with a lower share price to have a larger market cap.
Market cap represents the true value of a company as perceived by the market. By factoring the number of outstanding shares along with share price, we get a better picture of the company’s size and, most importantly, how multiple companies are similar or different from one another.
Market Cap Limitations
Market cap is a useful tool to describe and categorize a company, but it’s not a perfect measurement.
The market price (which is one of the variables to calculate market capitalization) doesn’t necessarily reflect how much a piece of the business is worth. In many cases, shares are undervalued or overvalued by the market. To determine the value of a company (and ultimately whether you should buy shares), you’ll need to perform a deeper analysis of the company’s fundamentals.
Furthermore, although market cap measures the cost of buying all of a company’s shares, it does not reflect how much it would cost to acquire the company in a merger. Generally, you get a better deal when you buy a lot of something. You know that savings you get when you buy 50 rolls of toilet paper from Costco? Those economies of scale apply when buying massive companies, too.
Market Cap and Your Investment Strategy
To reduce the risk, it’s generally smart to diversify your portfolio by investing in a variety of stocks with different market caps. True diversification is more than just selecting a bunch of stocks with different market caps. You could also diversify by country (emerging markets and developed markets) or invest in other asset types like bonds as well as stocks. This way if one category suffers from market conditions or economic developments it won't drag down your entire portfolio.
Now that you understand market capitalization, use the knowledge to take the next step and start investing. With the help of Wealthsimple, you’ll gain a personalized investment portfolio, low fees, and friendly financial guidance. Sign up now to start investing in minutes.
