Investors hear a lot about a company’s market cap, or market valuation. What does this mean and how important is it for investors to understand?
At the time of writing this piece, one of the biggest news stories was the fact that streaming giant Netflix (NASDAQ: NFLX) had surpassed Disney (NYSE: DIS) in market capitalization, hitting a new all-time high. This certainly sounds like a big deal for a company which was suddenly under threat from the rise of Disney+.
To a novice investor who does not quite understand what a market capitalization is though, it might not mean much. To make it simple, here is the exact definition of a market cap:
“Market capitalization is the total dollar value of all outstanding shares of a company.”
Seems straightforward, once you understand that ‘outstanding shares’ are all the shares of a corporation or financial asset that have been authorized, issued, and purchased by investors and are held by them.
How is a company’s market cap calculated?
Actually, calculating a company’s market cap is simple:
Market Cap = Share price x total amount of outstanding shares
But before a company can determine their share price and number of outstanding shares though, they must undergo valuation processes involved with going public.
Determining a valuation and share price
A private company receives a valuation based on what analysts estimate the company should be worth. Then, prior to going public, a company’s value is privately determined by underwriters such as Wells Fargo (NYSE: WFC) or Goldman Sachs (NYSE: GS).
Depending on the amount of shares being made available, the company’s individual share price is determined by the value of the company divided by each share:
Share Price = Value of company/Number of outstanding shares
Once it is publicly traded, the company’s stock price is determined by supply and demand. This is directly related to fluctuations in the market, and can be determined by any number of factors including a rise in competition or just an overall market downturn, such as the one caused by the COVID-19 pandemic.
Determining the number of shares to make available
When going public, different exchanges such as the Nasdaq Composite (NASDAQ: NDAQ) and New York Stock Exchange (NYSE: NYX) will have a minimum share count. For example, to list on the Nasdaq, a company must have a minimum of 1.25 million shares outstanding, which excludes those held by officers, directors or any beneficial owners of more than 10% of the company.
There is no limit on the amount of shares that a company can issue during or after incorporation. This means there can be a massive variety in the number of shares offered by a company.
For example, as of December 31, 2019, Apple (NASDAQ: AAPL) has 4.45 billion shares outstanding, while Amazon (NASDAQ: AMZN) has only 498 million. However, as of April 21, 2020, both companies are worth approximately the same, with a market cap of $1.19 trillion.
Having more shares outstanding does not make a company more valuable. This is because the more shares there are, the smaller slice of the overall pie each one represents, so they’re individually worth less. Thus, the total number of outstanding shares of each company produces its market capitalization.
Why is a market cap important?
When considering an investment, whether it’s in an industry stalwart like Microsoft (NASDAQ: MSFT), or a riskier, hype-driven stock such as Beyond Meat (NASDAQ: BYND), it is always important to evaluate the market cap.
If you focused solely on individual share price when deciding who to invest in, you could end up investing in a company for the wrong reasons, as more expensive stock does not necessarily make a company more valuable that one with cheaper stock. By that logic, Apple would be worth less than Tesla.
Another reason it is important is because the size of a business’s market cap determines which broad category of publicly traded company it falls under: small cap (under $1 billion), mid cap ($1 billion to $10 billion), or large cap ($10 billion plus).
Generally speaking, small-cap stocks have a greater runway for growth, but can also be riskier investments because of the uncertainty of the companies’ future performance. Large-cap stocks are usually considered safer bets and yield consistent annual returns, but may not have much room for any more substantial growth.
Other ways to evaluate a potential investment
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Quickfire Round
It allows investors to understand the relative size of one company versus another.
Market capitalization is essentially a synonym for the market value of equity.
The two are dependent on one another. Market capitalization is simply the value you get when you multiply all the outstanding shares of a stock by the price of a single share.
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