Long-term investors try to understand the relationship among company revenue, risk and potential returns in order to balance their stock portfolios. Market capitalization (market cap) is a key figure they use when deciding whether to invest in a particular company because it makes it easy to compare businesses of similar size in the same industry.
For companies considering an initial public offering (IPO), it's important to understand market cap because analyzing comparable companies is one of several factors used to determine IPO valuation.
What Is Market Capitalization?
Market cap represents the market value of a company based on its current share price and the total number of its outstanding shares. Market cap provides a convenient way to track and compare publicly traded companies based on their valuation. Comparing the market caps of similar companies and help investors decide whether a given company is overvalued, valued correctly or undervalued by the 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 $10 billion; and small-cap, for companies valued roughly from $300 million to $2 billion. These market cap sizes have traditionally also corresponded to a company's stage of development, but nowadays this is far less true. Especially for companies in industries such as information technology and biotechnology, there is a growing incidence of high valuations that are out-of-proportion to the company's maturity.
Because a company's market cap is determined by its share price, it represents investors' perceived value of a business, rather than its book value. It reveals how much investors are willing to pay for the company's stock and, as such, the company's susceptibility to economic headwinds is "priced in.”
Still, market cap doesn't tell the whole story of a company's value. Companies with similar market caps may have different price-to-earnings (P/E) ratios, as well as dissimilar levels of outstanding debt or authorized shares that have not yet been sold to the public. Market cap also leaves out considerations like present and future cash flow and the resale value of company assets. A company with a market cap much lower than its resale value could be a target for a takeover.
In general, the higher a company's market cap, the more it can benefit from greater coverage by stock analysts and more access to loans for reinvestment. The higher the valuation, the more likely the business has capital to deploy and invest in future growth.
- 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 outstanding shares, so it reveals how much investors are willing to pay for a stock.
- Mutual fund portfolio managers and other investors use market cap as a standard way to categorize investments and compare the performance of similar investments.
- Market caps are classified by size/dollar value (small, medium and large), which historically has corresponded to a company's stage of development. But this relationship has decreased over time.
- For companies that are preparing to go public, understanding market cap can help 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 a company and where it is in its development. Businesses also use market cap to assess targets for their acquisition and partnering strategies and as a factor in their own investment planning. Stock indexes and investment funds group companies together by market cap for comparison purposes and to provide investors with options for portfolio investment strategies. Market cap is particularly helpful for diversifying investment portfolios to reduce the impact of a decline in one market cap category. For example, last year the Dow Jones U.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 only 23.58% — a significant difference for investors.
Many factors can influence a company's market cap, including changes in share value, the number of shares issued or an exercise of warrants that increases the number of outstanding shares. Stock splits or the issuance of dividends do not typically alter a market cap since, in both cases, the increase in shares offered is accompanied by a price drop. For example, in the case of a 2-for-1 stock split, the share price is halved.
Importantly, market cap doesn't necessarily reflect how much a business is actually worth because it doesn't account for certain crucial factors, such as a company's cash reserves or debt. Another calculation, called " enterprise value," better represents the total value of a company and is defined as its market cap plus outstanding debt minus available cash. Enterprise value is used to calculate the potential cost to acquire a company and to compare the relative performance of different companies.
How to Calculate Market Cap
Market capitalization is calculated by multiplying the number of a company's outstanding 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 share has a market cap of $3 billion, while another company with 20,000 shares selling at $1,000 per share has a market cap of $20 million. If you looked only at their per-share prices, you wouldn't know the first company was the more highly valued of the two. Investors often consider companies with larger market caps to be safer investments over the long run.
Free-Float Market Cap
Another way to calculate market cap, called the free-float method, excludes shares not freely traded on the public market because they are locked in by company executives, pledged as collateral to lenders, held by trusts or private equity funds or any other reason. Market caps calculated using the free-float method are always less than those calculated with the basic formula, and many indexes 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 the risk/reward of owning its stock. Businesses can use market cap as a first step in assessing the affordability of an acquisition target or a capital infusion to fund growth. Leaders of public companies keep a close eye on any change that could impact market cap. Both internal changes, like a management shift or layoffs, and external events, like earnings reports or lawsuits, can cause share prices and, therefore, market cap, to shift.
Asset management companies use market cap as one of the standard ways they categorize investment offerings. Mutual fund portfolio managers and investment advisers may have proprietary guidelines for categorizing companies by market capitalization. The popular Standard and Poor's (S&P) indexes for large-caps, mid-caps and small-caps, for example, consider stock market value, financial performance, business sector and historical factors in categorizing the companies for its indexes. One reason they do this is that market cap typically aligns with other factors. Large-cap stocks are generally considered lower risk with less aggressive growth potential than small-cap stocks, which are considered higher risk with more growth potential. Mid-cap stocks generally fall 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-cap stocks. And because each market cap category has historically reacted differently to market and economic conditions, many investors diversify their investment portfolios to maintain 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 managers and investors a snapshot to help them compare the relative sizes of companies. The different market cap categories come with some rule-of-thumb assumptions regarding the maturity of a company, how much capital it can deploy and its risk-versus-return potential.
At the extreme ends of the market-value spectrum you'll find the largest and smallest companies that are traded on the major indices. Mega-cap companies have a market value over $200 billion. While there are only a handful of corporations this size, they make up approximately 20% of the S&P 500 Index for large-cap stocks. Mega-cap stocks include companies like Apple Inc., Microsoft Corp., Amazon Inc. and Facebook Inc.
Large-cap stocks are those with market valuations of more than $10 billion. When the categories came into use, companies with large market caps were typically well-established and in more mature industries but, today, younger companies that investors believe have high growth potential sometimes run up into large-cap territory. In general, though, large-cap stocks are supposed to deliver a consistent return on investment with less risk than smaller stocks but with only moderate growth prospects. Large-caps include the best-known brands in the world and are leaders in their industries. They tend to generate more cash than they need to run their businesses and return that extra capital to shareholders as dividend payments. They are considered a safer long-term investment than smaller-cap companies and tend to outperform small caps in down markets — which is one reason why the better performance of the Dow Jones Small-Cap Index mentioned above relative to its sibling large-cap index made news.
Mid-cap stocks are those with market valuations between $2 billion and $10 billion. Companies in this range are typically in industries experiencing or expected to experience growth. They have a track record of increasing their market share and improving their competitive position but may still face future challenges trying to disrupt better-funded large-cap competitors or fighting off competition from other mid-caps and promising upstarts. Mid-caps might be fast-growing companies that have outgrown their small-cap status or former large-cap companies that were disrupted and have since declined in their markets. Mid-caps may offer more growth potential than large caps and possibly less volatility than small caps.
Small-cap companies are those with market valuations between $300 million and $2 billion. Companies with smaller market caps are usually considered growth stocks and are typically younger companies in newer industries or niche players in growing 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 are historically more susceptible to industry and economic downturns and tend to underperform during "bear markets" and outperform in "bull markets," although that was not the case in 2022.
Micro-caps are businesses with market valuations of $50 million to $300 million. Also known as "penny stocks," micro-cap businesses have often gone public with new products or services. They are highly speculative but can have a huge upside.
A Quick Breakdown of Standard Market Cap Categories
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 a certain price at a certain time or when companies issue securities or debt that can be converted into shares of stock. If the difference between outstanding and authorized shares is large enough, then the number of outstanding shares might rise quickly when such options are exercised, driving down the price of existing shares. In this case, investors can use the diluted market cap formula to calculate what the potential market cap would be if all stock options were exercised and all convertible securities were exchanged for stock. A fully diluted market cap is calculated by multiplying the current share price times the total number of shares authorized, or:
Fully diluted market cap = price per share x shares authorized
For instance, a company with 20 million outstanding shares at $10 a share could also have convertible securities eligible to be exchanged for another million shares. In that case, the company's market cap of $200 million would translate to a fully diluted market cap of $210 million. It's important to note that a fully diluted market cap is merely a projection of what could happen. Share prices may rise or fall before the event, and the event itself, by increasing the 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 caps change frequently over time. Cryptocurrency is a prime example. Cryptocurrencies like bitcoin are virtual coins, not shares, but the market capitalization concept remains the same. You can calculate a coin's market cap by multiplying all circulating coins by the price of each one.
Cryptocurrency, however, is issued frequently and typically exhibits greater price volatility than stocks, so a coin's market cap will also fluctuate rapidly. And as new coins enter the market, they theoretically reduce the value of existing coins, so the standard market cap formula will not accurately calculate the potential market cap. Therefore, analysts and investors use diluted market cap to understand potential changes to the price of a security, token or coin. And companies that maintain larger inventories of securities or crypto coins are at greater risk of price decreases.
Prepare for Public Markets With NetSuite Accounting
Midsize companies preparing to go public don't often have the necessary accounting controls to support financial statements that are compliant with U.S. Generally Accepted Accounting Principles (GAAP). Yet their accounting systems and processes have served them well up to now — so they may not realize what's missing. For example, many small business accounting software programs work well enough for cash accounting, which is all a business may need for tax-filing purposes, but they require workarounds or simply can't handle accrual accounting, which is required for GAAP compliance and, therefore, public markets.
Enter NetSuite Cloud Accounting Software, the core of NetSuite's enterprise resource planning (ERP) system. NetSuite Accounting includes all the accounting controls necessary for GAAP compliance and then some. With NetSuite, all transactions are logged, including information about who made the transaction and when — a simple function but one that can be turned off in some accounting programs, reducing auditability. Another crucial accounting function for public companies, those eyeing an IPO or simply looking to raise capital, is segregation of duties, which is a fraud-defeating principle designed to ensure that anyone who has the authority to pay a bill doesn't also have the ability to create a bill. Moreover, NetSuite Accounting automates the creation of crucial financial statements necessary for public markets but with the flexibility to also produce internal versions that include sensitive data and discussions that only C-suite executives should see.
Market capitalization is a useful and widely used measure that gives investors and business managers an immediate sense of the size of a company. Market cap is incorporated into several deeper business metrics that attempt to assess a company's financial performance and future prospects, such as enterprise value calculations. For midsize companies considering public market entry, better understanding market cap and related metrics can help them estimate how much capital 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 affect its market capitalization — essentially, anything that influences stock market prices. This is because market cap is simply the price of one share of a company's stock times the number of that company's outstanding shares. If the market is trending up or down, a company's stock is likely to rise or fall along with that trend, affecting its market cap. Factors specific to the company are likely to have a more pronounced impact on its market cap, especially the company's business performance as reported in quarterly financial statements. Stock buybacks and new share issuance can also impact market caps because they change 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 considered a mega-cap.
What makes market capitalization change?
Market capitalization is calculated as the number of outstanding shares of a company's stock times the price of a single share. Therefore, any changes in share price or outstanding shares (such as a stock buyback, employees exercising stock options or lenders exercising options to convert debt into shares) will cause market cap to change.
Market cap vs. free-float market cap: What's the difference?
Market capitalization is calculated by multiplying the number of a company's outstanding shares times the current market value of one share. Free-float market capitalization excludes shares not freely traded on the public market (such as those locked in by company executives) and is always less than market cap calculated with the basic formula. To calculate free-float market cap, subtract the number of locked shares from the number of shares 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 a company's size and usually also corresponds to a company's stage in business development. Understanding the relationship between company size, return potential and risk is 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 considered more conservative investments than small-cap or mid-cap stocks, the theory being that they pose less risk in exchange for less growth potential. The higher the valuation, the more likely the business has capital to deploy or invest in future growth. A higher market cap also tends to attract more analyst and press coverage 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 by their investment goals. While large market caps typically represent stability, smaller market caps have more room to grow. Investors typically build stock portfolios with a mix of market caps to offset any declines in the value of one market cap category.
What does it mean if market cap is high?
A high market cap usually indicates a more mature company with market valuations of more than $10 billion. Large-cap stocks are usually considered to be safer investments than mid-cap or small-cap stocks but typically have more moderate growth prospects.