Market cap is an important metric to help you choose stocks to trade. This post is dedicated to helping you figure it out, with a clear definition of what market cap is, how to determine it, what it means, and how to use this information to your trading advantage.
If you’re a new trader, it’s possible that you have no idea what market cap is or what it means.
Don’t feel bad. There are many traders with years of experience who don’t necessarily have a great grasp on the concept.
Nope, a market cap isn’t a trendy hat for traders. It’s an important metric in helping you choose stocks to trade. It can give you much insight about the company offering shares of a stock, and should absolutely be part of your research before deciding on a trade.
So, how can you calculate the market cap of a given company, and why does it matter?
This post is dedicated to helping you figure it out, with a clear definition of what market cap is, how to determine it, what it means, and how to use this information to your trading advantage. What is Market Cap?
Download the key points of this post as PDF.
Market cap, which is short for market capitalization, refers to the total value of a given company’s outstanding shares.
Table of Contents
- 0.1 What Does Market Cap Mean?
- 0.2 What is a Stock’s Market Value?
- 1 How To Calculate Market Capitalization
- 2 What Could Impact a Company’s Stock Market Capitalization?
- 3 Different Types of Market Capitalization
- 4 The Bottom Line
What Does Market Cap Mean?
What does market cap mean, exactly? To explore the actual meaning of market cap, consider what Investopedia has to say:
“Market capitalization refers to the total dollar market value of a company’s outstanding shares. Commonly referred to as ‘market cap,’ it is calculated by multiplying a company’s shares outstanding by the current market price of one share. The investment community uses this figure to determine a company’s size, as opposed to using sales or total asset figures.”
Good news: Determining a company’s market cap is extremely easy. It can be calculated using a simple formula, and can be used as part of your fundamental research and analysis when trading stocks.
The information you gain from this number can be a helpful method of filtering stocks of interest. Combined with the filtering tools in trading platforms like StocksToTrade, this can help you narrow down your choices.
Looking at the market cap of different companies can also offer an opportunity to choose stocks from companies of various sizes, which can add diversity to your portfolio.
What is a Stock’s Market Value?
An important aspect of determining a stock’s worth is looking at its market value. The market value is the price that an asset would command.
Figuring out the general market value of stocks and some other financial instruments like futures is pretty simple, since the market rates are extremely easy to find.
A company’s true market value requires more than just the market cap. For the most accurate snapshot, you need to consider things like the P/E Ratio (Price to Earnings Ratio), the return on equity, and the EPS (Earnings Per Share) of the company in question.
These different calculations can help you get a bigger picture on the company and its value. This can help you figure out long-term growth potential, potential dividends, and how beneficial a company’s stock could be for your overall portfolio.
Market Cap vs. Market Value
Considering the market value of a company can be extremely helpful in allowing you to determine the overall value of an investment.
Both market cap and market value can be used to review the value of a company. They sound similar, and sometimes people use the terms interchangeably.
Maybe the confusion arises because they sound similar, and both refer to the company’s value.
However, while these are both ways to measure the value of a company, there can be differences in how they’re used in your research and analysis.
Here’s the deal. The market cap is a metric that is based on the stock price. To determine a company’s market cap, all you have to do is multiply the current share price by the number of shares outstanding.
With that in mind, it’s kind of understandable why the term market value is used interchangeably with market cap. However, considering the copany’s value frequently goes beyond just considering the market cap.
The company’s market value refers to not just the market cap calculation, but requires a bigger and more broad view of the overall size and sturdiness of the company when considering a stock for a potential trade.
Market Value vs. Stock Price
Can a company’s stock price tell you everything about a company’s market value? Sorry, but it’s not as easy as that.
It’s a common misconception that the price per share is a strong indicator of a company’s value. Yes, it is an indicator, but it can’t be considered without backing it up with other information and metrics.
However, to assume it’s as simple as a high share price meaning high value is not quite accurate. That’s an extremely short-sighted view, and it’s a mistaken perspective frequently held by new traders.
On one hand, this seems like it makes no sense. After all, how could it be possible that a stock commanding a $100 per share cost could actually be worth less than a stock with a $15 per share price? It boggles the mind — and confuses many.
If you’re confused, don’t worry too much. Once you learn how to do fundamental analysis, you’ll learn that there are many more things to consider in determining the value of a company.
As for the price of the shares, here’s why it can’t be used as the end-all indicator. The price per share is constantly fluctuating based on the market, the business climate, and even the season.
Additionally, the number of outstanding shares can shift too. So it’s not necessarily the best way to gain insight on the value of a stock.
Market capitalization can be a metric that bridges this gap. By calculating the market cap, you can gain a better idea of the actual value of the company on an overarching scale. This can give you a much better clue as to the value of a company.
It should also be noted that the market value can differ from the so-called book value. If the stock is under the book value, for instance, it might be considered undervalued. This means it’s trading at a very big discount.
Of course, it doesn’t always work in a black-and-white way. For instance, if a stock is trading over the book value, it doesn’t necessarily mean the stock is overvalued. It could just mean that a catalyst of some sort has increased the supply and demand. This could be temporary.
How To Calculate Market Capitalization
Market Cap Formula
The market capitalization of a company is easy to calculate. All you need is the magical market capitalization formula. Don’t worry, it’s not complicated.
In fact, it’s almost so easy it hurts. All you have to do is multiply the company’s total number of shares by the current share price.
Let’s put that into a practical example. Say Company X has 1 million shares, and each share costs $4 each. This means its market cap is $40 million.
Easy, right? Determining the market cap is easy, but understanding what it means is where it gets a little bit more involved.
The number you calculate with the market cap formula tells you the size of the company in question, and the amount of money that would be tied up if it were to be sold right this minute. In that way, it’s considered one of the key indicators of the market value.
Of course, without context these figures don’t have too much meaning. For instance, a company with a $50 million market cap might seem really impressive, until you consider it against a $10 billion market cap.
Because of this, the results of the formula in and of itself shouldn’t be just used without considering other aspects about the company and stock.
Market Capitalization Ratio
The market capitalization of a company can be used to help make a comparison between the value of a business to its market value. One of the ways you can evaluate this information is the book-to-market ratio.
The book value can be determined by looking at the business’s historical cost in the market.
According to Investopedia, this can be figured out through this calculation:
Book-to-market ratio = common shareholders’ equity / market capitalization
By calculating this ratio, you can gain a better idea of the market value of a company as opposed to its actual worth.
Example of Market Capitalization Analysis for Traders
How might you, as a trader, use the market cap in your analysis?
In particular, the market cap formula can help you power through simply looking at the stock price and delve a little deeper into the value of a company.
Here’s an example. Let’s say that one company has stock shares available for $200, and the other has shares for $30. It is tempting to think that the company with the higher priced shares is bigger and better, and therefore a better investment.
Hold up. But if the first company has a market cap of $200 billion and the second one had a market cap of $225 billion, all of a sudden that comparison doesn’t seem quite as cut and dry.
If you had only looked at the stock price, you wouldn’t be looking at the big picture. The market cap can level the playing field and help smooth out edges like the size, the outstanding shares, and other considerations.
What Could Impact a Company’s Stock Market Capitalization?
A company’s market cap is by no means a one-and-done sort of deal. What can affect or change a market cap? Two key things:
- A significant change in stock price. If there’s some major event that affects the stock price in a big way, it can affect the market cap. Yes, of course any shift in the stock price will have some effect, but to really impact the market cap in a noticeable way, it would have to be bigger.
- The company issues or repurchases shares. A big change to the amount of shares available can affect the market cap. This means if there is a stock split or some other big change in the amount of shares, it can have an effect.
How Does Market Capitalization Affect Stock Value?
Now that you’ve got an idea of what market cap is, you may be wondering how it affects the stock value.
In a nutshell, the market cap can give you an indication about the value of a stock, but it shouldn’t be used as your sole indicator. Why? For these reasons:
- Market cap doesn’t tell the whole story. While the market cap can help you gain some important basic information about a company, it doesn’t tell you the entire story. You still have to do your fundamental research.
- Stock shares aren’t always valued properly. While it might seem like the market cap will tell you what the business is worth, it’s not quite as easy as that. Because stock shares can be over- or under-valued, this can skew the figures. Supply and demand is what rules stock price, and it can shift based on what people are willing to pay.
- Market cap doesn’t tell you the total value of the business. If a company has a market capitalization of $2 billion, it doesn’t necessarily mean that it would command that price if someone else made an offer to buy it.
There are many more factors to consider in such a case. To really get a realistic idea, you’d want to figure out the enterprise value — but that’s a subject for another post!
Why You Need to Apply for My Trading Challenge
I can be a broken record about this, but I am fanatical about urging my students in the Trading Challenge to do their research. The market cap is a great basic research tool because it can help you uncover important information about a company, which can reduce the risk factor involved in a trade.
As a teacher and mentor, I want to give my students the edge I had to gain the hard way, so that they can avoid making some of the mistakes I made. The stock market is risky. You can’t change that, but you can help control your losses, and part of that is realized through mitigating risk.
Part of this goal is realized through teaching my students important methods of doing research. Incorporating market cap and other methods I teach my students is a great way to help make your trades more tactical as you attempt to reduce risk.
Different Types of Market Capitalization
Once the market cap is calculated, companies can be put into different general ranges to help with ease of analysis. While on the most basic level those cap sizes will be divided into large cap, mid cap and small cap, there are now extreme sectors on either end, too.
There aren’t necessarily official numbers for these divisions, but most will fall into these categories:
These are massive companies with a market cap of $200 billion and above. To attain this status, you must be an industry leader. A heavyweight commodity company like Google, or big guys like ExxonMobil fall into this highest echelon of market capitalization.
Apple, which recently reached the milestone of being the first-ever company to attain a market cap of $1 trillion, might create an even larger category!
These are large companies that fall between a $10 billion and $200 billion (yes, a big range) with the market cap formula. As you might imagine, these are highly established companies. Either they’ve been around for a long time or are part of major industries.
For instance, the Walt Disney Company would be considered a large-cap company. Companies like Walmart or General Electric also fall into this mix. Along with the mega caps, they are considered blue-chip stocks. They’re generally stable, secure, and often deliver long-term, slow-but-steady value. The idea here is that the share values increase steadily, so you can steadily mount returns and dividends.
These are companies that fall between $2 billion and $10 billion with the market cap formula.
Obviously they’re established companies, but not quite as big as the large- or mega-cap companies. They still have room to grow. They’re more likely to be growth stocks, which hold the promise of gains in value with a shorter time frame than the bigger guys. They might not be industry leaders now, but could be in the semi-near future.
While buying a stock from a mid-cap company might not have the same risk level as penny stocks, they can carry more risk than trading the stock of a large-cap company. The appeal lies in the fact that they aren’t too scary-risky, yet might offer a quicker rate of return.
As a reference, an example of a mid-cap company would be Prestige Brands Holdings. This is a pharmaceutical company that sells a variety of recognizable over-the-counter medications including oral care products, sleep aids, pediatric care items, and digestive aids.
These are companies that fall between $300 million to $2 billion with the market cap formula. They are often new companies or companies within up-and-coming industries. They might have gone public pretty quickly to raise money. It can be hard to find big financial histories of these companies for analysis. They sometimes provide a quicker rate of return, but possibly with higher risk.
These are companies that fall between $50 million to $300 million with the market cap formula.
This is where many penny stocks live. Some have a high chance of delivering profits, if they realize their potential — but since that’s something most of us will never know, they usually carry a high level of risk.
These are companies that fall below $50 million. These are, by far, typically the riskiest caps to invest in, and you’ll usually find them on pink sheets.
Is bigger better? When it comes to market cap, size matters. But is bigger better? Not necessarily.
Yes, bigger companies can offer some benefits. For example, they’re a often more proven, so the risk can generally be lower. These aren’t the types of companies that are likely to crash and burn.
However, the reduced risk can bring a higher asking price and slower movements, which may not deliver a quick return on your investment.
Many traders simply aren’t willing to wait, particularly if they have small accounts and are hoping for growth. If you’re part of this contingent, then you might want to try a different plan.
Smaller-cap companies, which are primarily what I and my trading students trade, are companies valued under $300 million. They rarely attract big buyers. This means that for you and me, there’s potentially more opportunity.
To sum it up, a large- or mega-cap label for a company just means it’s bigger — but not necessarily a better investment.
The Bottom Line
The market cap can prove useful for investors who are trying to decide whether to make a trade.
By calculating a company’s market capitalization, you can learn basic-yet-vital information about the size of the company in question and the basic risk level involved in a potential trade.
It’s important to keep in mind, however, that the market cap doesn’t reveal everything about a company. Therefore, the market cap should only be used as part of your research, not as your sole decisive factor for making a trade.
Do you use the market cap in your stock research?