After a court dismissed their antitrust lawsuit, Facebook surpassed a $1 trillion market cap. What does that mean?
All public companies have a market capitalization, aka market cap. It places a quantitative dollar value on a company, making it one of the key figures to understand about a stock. The market cap of a company is its value based on the number of outstanding shares and the current market price per share.
Market cap is an important number to know, but it’s not the only piece of data. As an investor, it’s best to understand a few basics about market cap, including: What does it mean and how is it determined?
TL;DR
- Market capitalization, or market cap, is a figure investors use to analyze the value of a publicly traded company.
- An initial market cap is determined at a companys initial public offering (IPO).
- The simple calculation for market cap is to multiply the number of outstanding shares on the market by the current share price of the companys stock.
- Publicly traded companies generally fall within one of three categories: large-cap, mid-cap, and small-cap.
- Market cap can shift over time, often due to a significant share price change, and its not the only useful measure of a companys value.
How the market cap of a company is calculated
A companys market capitalization, or market cap, is the dollar value of all shares of a company. You get this number by multiplying the current share price by the number of outstanding shares (a.k.a. shares that investors currently hold).
Market cap = Share price X Number of outstanding shares
When a company goes public, it typically uses investment banks as underwriters to help determine the companys value. The banks valuation techniques help establish what the debut price of stock will be and the number of shares they’ll offer.
For example, say a company has an IPO value of $500 million. In this case, the underwriter might decide to issue 25 million shares at $20 each. Alternatively, it could offer 50 million shares for $10 each. Either way, the initial market cap is $500 million.
After the IPO, plenty of factors can impact share prices. Supply and demand affects the price per share. Significant increases and decreases in stock price can affect the companys market capitalization.
A variation of calculating market cap is called free-float methodology.
A free-float market cap doesnt include any locked-in shareslike those held by company executives or governmentsin the calculation. Full-market cap accounts for both active and inactive shares, while free-float market cap only includes those readily available on the stock market.
Free float market cap = Share price X (Number of shares issued – Locked-in shares)
Most major indices, including the Dow Jones Industrial Average and the S&P 500, use the free-float method to calculate market cap.
What market cap means
Market cap is a measure of a companys value, but its not the only metric investors need to know.
For example, when you hear that a company has a market cap of $1 billion, you can sort that company into the small-cap category, which is useful for gauging how much potential there is for it to grow.
Heres what market cap is not:
- Equity value: Equity value is the combined figure including the value of company shares and loans made available by shareholders.
- Enterprise value: Enterprise value factors in market cap plus all company debts and cash on its balance sheet. Its a more comprehensive figure than market cap.
Market cap is one useful metric for investors analyzing company size and growth potential. It enables a quick and simple comparison of two or more stocks. Market cap offers a peek into a stock’s risk potential before an investor purchases shares.
Main market cap categories: Large, mid, small
Market capitalization for companies generally falls into one of three main categories:
- Large-cap: These are companies with a market capitalization of $10 billion or more. Typically, large-cap companies are considered to be more conservative and therefore pose lower risk for investors because of their staying power and reputation.
- Mid-cap: These are fairly established companies with a market capitalization between $2 billion and $10 billion. Mid-cap stocks are often in a phase of growth and could represent a middle ground in terms of risk and rewards as compared to large- and small-cap stocks.
- Small-cap: These are companies with a market capitalization between $300 million and $2 billion. Theyre often startups that serve a niche market, which means they can be riskier investments. For investors with a long time horizon and the ability to withstand short-term volatility, small cap stocks can offer significant rewards.
Two other categories exist but typically contain fewer companies. Micro-cap companies are valued between $50 million$300 million, while mega-cap companies are valued at $200 billion or more. (No, Facebook doesn’t join the mega-mega-cap category for reaching $1 trillion.)
Can a company’s market cap change?
A companys market cap can increase or decrease. Typically, this happens when there are major changes in the share price of the stock or when an investor exercises a large number of warrants.
Market cap increases if the share price of the stock increases significantly. The market cap can decrease due to a major drop in share prices.
When an investor decides to exercise warrants, this causes an increase in the number of outstanding shares, which in turn dilutes the existing value.
However, stock splits and dividends don’t usually impact market cap. This is because the share price is adjusted to correspond with any change to the number of shares.
Market cap is important, but it has its limitations
Investors should take market capitalization of companies into consideration when making investment decisions. This may be as simple as deciding what percentage of your portfolio should be allocated towards small-cap and mid-cap stocks versus large-cap stocks (hello, diversification).
If your portfolio can handle a bit more risk and has a longer time horizon, you might lean more heavily on small- and mid-cap stocks. Since they may be more volatile but also have more room to grow larger, you stand to gain good returns on those investment holdings.
However, when you need a more stable portfolio (possibly due to a shorter time horizon), greater focus on large-cap stocks could be advantageous.
That said, market cap is somewhat limited in what it can tell investors. For one thing, a large-cap stock might sound too big to buy because you want more growth. But even a $10 billion company still has potential to grow larger in market cap.
In addition, its possible to earn strong returns per share, regardless of how fast a companys market cap grows.
Even if a company’s market cap is impressive, that doesn’t guarantee growth. Due diligence goes beyond one metric.
As a general rule, most investors maintain a mix of market cap sizes.
Bottom line
Market cap is the shorthand for market capitalization, or a metric that determines the value of a publicly traded company. While market cap doesnt tell you everything you need to know before buying stock in a company, it can help you learn about a company’s value, categorize your investments, manage your risk, and easily diversify your portfolio.