How can you use market capitalization to help you choose stocks to trade?
Nope, a market cap isn’t a trendy hat for traders. Market cap can give you an overview of how the market currently values a company. It can give you insight into the company behind the stock. And it can give you feedback about how other traders value the company.
Let’s take a look at market cap in depth. Plus, I’ll tell you how to determine it, what it means, and how to use this information in your trading.
So, how can you calculate the market cap and why does it matter?
Table of Contents
- 1 What Does Market Cap Mean?
- 2 What Is a Stock’s Market Value?
- 3 Market Capitalization Example
- 4 Why Is Market Cap Important?
- 5 How to Calculate Market Capitalization
- 6 How to Use Market Cap
- 7 What Could Impact a Company’s Stock Market Capitalization?
- 8 How Is the Market Cap Determined?
- 9 Different Types of Market Capitalization
- 10 The Bottom Line
What Does Market Cap Mean?
Market capitalization — or market cap for short — is the total market value of all outstanding shares.
Investors may look at the market cap to find stocks from companies of various sizes and diversify their portfolios.
Market Cap vs. Free-Float Market Cap
Again, the market cap includes all the outstanding shares. The free-float cap is the total market value of the free-float, usually referred to as simply ‘the float.’ The float is the number of shares available to the public to trade.
The free-float cap is always smaller than the market cap. The number of shares in the float is always less than the total outstanding shares.
To calculate the free-float market cap, just multiply the float by the current share price.
What Is a Stock’s Market Value?
A key part of determining a stock’s value is looking at its market value. The market value is the stock’s current price. It’s the price at which the stock currently trades.
Fundamental traders often pull in other considerations like the earnings per share (EPS) and the price to earnings (P/E) ratio. They do so to try to determine what a company’s market value or book value should be.
But the reality is that the market value is what a buyer’s willing to pay for it. The stock market provides constant feedback … and the last price is the market value — no matter what you think. Until the next trade anyway.
Market Cap vs. Market Value
Both market cap and market value can be used to review a company’s value. They sound similar, and many people use the terms interchangeably.
Here’s the deal … The market cap is a metric that’s based on the stock price. To determine it, simply multiply the current share price by the number of shares outstanding.
Fundamental traders try to determine a company’s market value going beyond just the market cap calculation. This requires a bigger and broader view of the overall size and stability of the company — along with its assets and projected sales.
The market value is a theoretical number that could be the price at some point in the future. The market cap is the actual value as determined by the free market.
But really, the market cap is the truest measure of the market value. It’s direct feedback from a free trading market.
Market Value vs. Stock Price
The market value could become a reality if the stock price starts to agree with this fundamental-based value.
And short squeezes happen. That’s exactly why you have to look at the big picture.
Most people don’t buy stocks based on current sales or assets. They buy stocks for their potential future value.
The market value, stock price, and market cap can shed some light on the stock’s story … But you’re getting an incomplete picture. Chart patterns can help you understand more about the stock, its history, and its price action.
Market Capitalization Example
Let’s look at a big company with a huge market cap, Microsoft Corporation (NASDAQ: MSFT). As of this writing, MSFT was trading around $173 per share.
MSFT has 7.7 billion shares outstanding. Multiply that by the current market value of the shares, $173, and you get the resulting market cap of $1.32 trillion.
See, math isn’t so scary after all.
Why Is Market Cap Important?
Market cap gives us a way to compare stocks to each other. Just because two stocks trade at the same price doesn’t mean they have the same value.
The stock price is only one metric used to determine a company’s overall market value.
As of this writing, Toyota Motor Corporation (NYSE: TM) trades for about $124 per share, and its number of outstanding shares is about 1.4 billion. That gives TM a market cap of almost $202 billion.
As you can see from this comparison, the share price doesn’t always reflect the company’s value. You can use the current market cap to compare stocks beyond just the stock price.
How Does Market Capitalization Affect Stock Price?
So now you’ve got an idea of what market cap is … You may be wondering how it affects the stock price.
There are two more terms you need to really understand the relationship — overvalued and undervalued.
Buyers believe the opposite. They believe the market cap should be higher. So they buy the stock at what they perceive as a discount.
Remember that all trades are only possible because someone else believes the opposite of you. Think about it … People buy because they think the price will go up. Then they sell when they think the price is going down.
Stock price and market cap are directly correlated. When market sentiment is that the stock is overvalued, both values sink. When the attitude leans toward undervalued, the stock price and market cap rise in unison.
How to Calculate Market Capitalization
The market cap is listed on the stock quote page. Just look for ‘market cap’ and the dollar sign next to it. Let’s take a look at where that number actually comes from…
Market Cap Formula
The market capitalization of a company is easy to calculate. All you need is the magical 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 outstanding by the current share price, just like we did earlier with TM and TLSA. Here’s the formula:
Market Cap = [Total Shares Outstanding] X [Current Share Price]
Easy, right? Determining the market cap is easy. But understanding it is a bit more involved.
The number you get with the market cap formula tells you a company’s valuation and the amount of money it would cost to buy every share at the current share price.
Market Capitalization Ratios
The market cap is half of the P/E ratio. Here’s the formula:
P/E Ratio = [Market Cap (price)] / [Net Income (earnings)]
The market cap is half of the free cash flow ratio and the price-to-book value.
Ratios can be useful as a point of reference to measure companies against each other. The market cap is a major figure used in critical ratios.
The point of all this is? Understanding. Know the P/E ratio exists. Know it’s a measure a lot of traders consider before they buy or sell a stock.
How to Use Market Cap
Sound complicated? It is. That’s one reason I stay away from fundamental analysis for trading. A basic understanding is good. But trying to figure out what a price should be before everyone else and then convincing everyone that your value is right? That’s an uphill battle.
The market cap is useful for comparing companies. And you can use it to determine the market’s current overall value for a company.
Example of Market Capitalization Analysis for Traders
And there can be other advantages to trading small-cap stocks. For one, there’s less competition from institutional traders and big traders.
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. So what can change a market cap?
A change in stock price.
If some major event affects the stock price in a big way, it will 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 a big percentage move.
How Is the Market Cap Determined?
We’ve been through the formula to calculate the market cap, but how do you actually determine that number?
There are two aspects of the market cap — shares outstanding and price per share.
The other number is determined by the free market. The buyer and seller have to agree for the transaction to go through.
Every time you buy or sell a stock, you help determine the market cap at that given point in time.
Just as a stock price can rise and fall in a short period of time, the market cap moves in the same manner since it’s directly correlated to the stock price.
How is the market cap determined? By the free market.
Different Types of Market Capitalization
Companies can be categorized by market-cap values. On the most basic level, companies are divided into large-cap, mid-cap, and small-cap. But there are now extreme sectors on either end, too.
There aren’t necessarily official numbers for these levels, but here’s a rough classification of each category…
These are massive companies with a market cap of $200 billion or more. These are industry leaders. Heavyweights like Google or ExxonMobil fall into the highest echelon of market cap.
Apple and Microsoft reached the $1 trillion market cap milestone … and might create an even larger category.
These large companies fall between $10 billion and $200 billion (yep, a big range). These are well-established companies. Either they’ve been around for a long time or are part of major industries.
Along with the mega-caps, they’re 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, and investors can steadily mount returns and dividends.
These companies fall between a market cap of $2 billion to $10 billion.
These are established companies, but they aren’t quite as big as the large- or mega-cap companies. They still have room to grow. They’re more likely to be growth stocks. And they could have the potential for gains in a shorter time frame than the bigger stocks.
They might not be industry leaders now … but could be soon.
A few examples of mid-cap companies include Wayfair and Planet Fitness. Both are fairly recognizable companies but not industry dominators.
These companies fall between $300 million to $2 billion. They’re often new companies or in up-and-coming industries. They might have gone public quickly to raise money.
It can be hard to find financial histories for these companies for analysis. And they can potentially provide a quicker rate of return … but often with higher risk.
These companies fall between $50 million to $300 million.
This is where many penny stocks live. Some have a chance of delivering profits if they realize their potential. But since most never will, it’s impossible to determine from the outside looking in. That’s why these stocks are risky. And if you decide to trade them, you better be prepared.
When it comes to market cap, size matters. But is bigger better? Not necessarily.
Bigger companies can offer some benefits. They’re often more proven, so the risk can generally be lower. These aren’t the types of companies likely to crash and burn.
But the reduced risk can bring a higher asking price and slower movements. Some traders just aren’t willing to wait. And if you trade with a small accounts, big stocks won’t suit your trading strategy.
The Bottom Line
The market cap can be useful for traders who are scanning for stocks that fit their trading plan and strategy.
This number can give you key information about the size of the company in question. And that can help you better understand the risk of trading it.
But keep in mind that the market cap doesn’t reveal everything about a company. Only use the market cap as part of your research, not as your sole decisive factor for making a trade.
Tell me what you think … Does the market cap affect your trading? Leave a comment below!