Market Capitalization is the price of a share of stock multiplied by the number of shares outstanding. If you were to buy all the shares of a particular company, what is the total amount you would have to pay? That amount is called market capitalization.
Say for example, we want to calculate the market capitalization of a company; we would take its current market price and multiply it with the number of its outstanding shares. If company ABC’s stock is selling for Rs 20 per share and there are 1,000 shares issued by the company, then the market cap for the company ABC is Rs 20,000. Since the stock price varies daily, the market cap for a company also varies from day-to-day.
Many equity mutual funds are categorized based on the average market capitalization of the stocks that the mutual funds own. The formula to find the market capitalization is stock price x total number of shares outstanding.
Significance of market capitalization
Market capitalization allows investors to understand the relative size of one company versus another. It also measures the equity market value of a publicly traded company. The very common misinterpretation about the stock price is higher the stock price, the larger the company. Stock price may not tell the company’s real worth.
The categorization of companies in different caps lets the investors know which company has growth potential and riskiness of a company. Large caps have experienced slower growth and lower risk and the small caps have experienced higher growth potential and higher risk. There are two methods of calculating market capitalization namely total float and free float.
Market capitalization is also a short-cut that helps you determine how big or small a company is without doing all calculations pertaining to sales, revenues, liabilities and debt. A company can adjust its share price through splits, but the market capitalization remains the same because they increase the number of shares in relation to the stock split they do. Splits which affect the stock price will not affect the market cap of a company.
Kinds of market capitalization
The companies are dividend into large-cap, mid-cap and small-cap. The terms mega-cap, nano cap and micro-cap have also come into common use. Listed below is the breakdown of types of market capitalization categories when you begin investing.
Micro cap: Micro cap category comprises of penny stocks companies having a market capitalization between $50 million to $300 million. The growing potential and the downside potential of these companies are parallel to each other that’s why they do not suggest the safest investment, and immense research should be done before entering into such a situation.
Small cap: The small cap consists of companies having a market capitalization between $300 million to $2 billion. Usually new companies or young companies come into this group.
Mid cap: Mid cap group comprises of companies having market cap between $2 billion to $10 billion. This also includes companies who are not the leaders but they are doing well in becoming one. These companies are generally considered as unstable compared to mega-cap and large-cap companies.
Large cap: Large gap comprises of companies having market cap between $10 billion to $200 billion. The companies that come under this group are Microsoft and Wal-Mart. Large cap stocks are considered stable and secure. The mega and large cap stocks are referred as blue chips.
Mega Cap: Mega cap consists of companies having market cap of $200 billion or greater than that. Mega caps are the largest publicly traded companies like Exxon typically the leaders of their industries come in this category.
Nano Cap: Under the nano cap, companies having a market cap below $50 million and these companies have low potential of growth and the risk is also high. Generally these stocks do business on pink sheets or OTCBB.
Drawbacks of market capitalization
There are some drawbacks to using market capitalization as a guide to a company’s size. One biggest drawback is that market capitalization does not factor into consideration a company’s debt. If a company is worth $10 million, but has debt of about $8 million, the picture looks a lot different. Other drawback is, it only represents the equity in a company or market.
Use of market capitalization
In the financial sector, the market cap of a company is important. Here are some areas where it is used.
1. Mutual funds: Mutual funds are geared towards a specific market cap category. Say for example, a large cap growth funds should only invest in large cap companies.
2. Investors: The market cap is another indication of how liquid a particular company’s stock is. The higher the market cap, the more shares outstanding.
3. Indexes- A lot of people are not aware that the S&P 500 has a requirement for the included companies to be at least $3 billion in market capitalization. Even though this stock market downturn has made many companies fail this test, the rule has not changed.
Market Capitalization is a term used on Wall Street that is extremely important. It is used or heard on the news and in financial textbooks and many few investors have knowledge about market capitalization. After reading this article, you will understand the concept and begin using it when putting together your own portfolio.
