Market capitalisation, often referred to simply as market cap, refers to the total market value of a public company’s outstanding shares. Consequently, market capitalisation is one of the most common methods of evaluating how much a company is worth at a particular point in time.
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Market Cap Explained
As explained above, market capitalisation measures the total market value of a public company’s outstanding shares. It presents investors with a simple, quick to calculate and accurate picture of a company’s true size and value.
By utilising the company’s current share price, market cap tells us what the market thinks a company is worth at a specific point in time. Remember, when a company lists itself on a stock exchange, its share price becomes subject to levels of demand and supply in the market.
Consequently, a change in share price causes a change in market cap. During market hours, a company’s share price is constantly fluctuating, meaning that its market capitalisation is actually fluctuating along with it.
How Is Market Capitalisation Calculated?
The calculation for market capitalisation is fairly straightforward, you just need to multiply a company’s current share price by the total number of shares it has outstanding.
The share price is easy enough to locate, but how can you find out how many shares a company has outstanding? This information can typically be found within a public company’s earnings report which, in turn, can be found in the Investor Relations part of their website.
As usual, this concept is probably best illustrated with an example. At the time of writing, Amazon’s most recent closing share price (4 November 2022) was $90.98 and, according to their Q3 results, they have 10,198 million shares outstanding.
Therefore, as of the market close on 4 November 2022, Amazon’s market cap was $927,814 million ($90.98 * 10,198m).
Market Cap vs Share Price
A common mistake amongst beginner investors in to look at a company’s share price and try to make assumptions from this figure alone. But, in reality, a company’s share price on its own tells us very little, if anything, about the company in question.
Market capitalisation is far more useful when analysing a company, as it gives us an accurate reflection of its size and its current market value.
For example, let’s say Company A has a share price of $10 and Company B has a share price of $100. Some may look at this and think that this means that, because it has a higher share price, Company B is worth more than Company A and, therefore, more successful.
But if Company A has 10 million outstanding shares, whilst Company B only has 100,000, we can calculate that:
- Company A has a market cap of $100 million ($10 * 10 million)
- Company B has a market cap of $10 million ($100 * 100,000)
Although Company A has a far lower share price than Company B, it has far more shares, which results in a much larger market cap.
What Does Market Cap Tell Us?
So, we know that market cap provides us with a simple and accurate picture of the size and value of a public company. But we can also use it to make certain deductions about a company’s profile and its prospect as an investment.
The first thing to note is that investors often split companies into categories depending on their market capitalisation. Below is a table which highlights how these different categories are usually defined. Bear in mind, these are rough guidelines, the exact definitions may vary depending on who you talk to.
Throughout the lifecycle of a company, they can move up and down throughout the various categories depending on whether they are growing or declining.
Earlier, we calculated that Amazon had a market capitalisation of around $928 billion which would make it a mega cap company, of which there are only a handful worldwide. But what, if anything, does this tell us?
Smaller Cap Companies vs Larger Cap Companies
One of the most straightforward interpretations of a company’s market capitalisation is that companies with a larger market capitalisation tend to have achieved a greater level of success than those with a smaller market capitalisation.
Consequently, investing in smaller cap companies tends to carry a higher level of risk as these smaller businesses are more at risk of being pushed out of the market by competitors. They are also more exposed to market downturns, as they have comparably less resources to ride out a recession.
Conversely, a company achieving the status of large cap or mega cap implies that they have achieved a certain level of success and are market leaders in their respective industry. Therefore, an investment in a larger cap company tends to carry less risk, as they are not as vulnerable to the same pitfalls as their smaller cap competitors.
However, as always, risk and reward have an inverse relationship. Although investing in a smaller company may carry more risk, the potential reward is great, as the company has plenty of room to grow in the future. On the other hand, a larger cap company, by definition, has already experienced high levels of growth and, generally, does not have as much room for future expansion.
Final Thoughts
Although market capitalisation can prove helpful when evaluating a company, you should be careful about drawing too many conclusions from it and only use market cap as one of many different indicators.
For example, you shouldn’t necessarily avoid a mega cap company because it doesn’t have the same growth potential as a smaller company. Larger cap companies have a lot to offer investors – often offering reliable returns and, sometimes dividend payments. Moreover, with the world the size it is, and constantly growing, who’s to say where the ceiling for growth really is.
Likewise, if you have done the research and have a strong conviction that a smaller cap company has what it takes to succeed in the future, you shouldn’t necessarily be deterred by the fact that the investment carries a higher level of risk.
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