Market Capitalization: How Is It Calculated and What Does It Tell Investors?
Companies may be ranked in terms of size using their market capitalization. Capital structure is evaluated based on the proportion of stock to total capital, but it does not take into account the choice of debt (or leverage) in financing the business. Enterprise value (EV) is a more all-encompassing metric of company size since it takes into account not only cash on hand but also debt and preferred shares. For many years, the insurance industry has relied on a concept known as “embedded value” (EV).
As a measure of the total market capitalization of all businesses listed across each stock exchange, it is also employed to rank the overall relative size of the world’s various stock exchanges. Comparing the overall market value of several stock exchanges or economic areas to other metrics is a useful economic exercise (e.g., the Buffett indicator). Roughly US$93 trillion was the total market valuation of all publicly listed firms in 2020.
Value of the Market: How to Determine It?
The first stage in establishing a company’s market valuation is its initial public offering (IPO) (IPO). To establish the worth of a business and the appropriate number of shares to issue at the appropriate price for an initial public offering (IPO), a company that is considering going public would employ an investment bank to do a valuation analysis.
When the IPO value is fixed by the investment bank, say at $100 million, the company may choose to issue either 10 million shares at $10 per share or 20 million shares at $5 per share. In both cases, the initial market value would be $100 million.
Why Is Market Capitalization Important?
Some investors and traders, especially new ones, might think that the price of a stock is a good indicator of that company’s worth, health, or stability. People may see a higher price of the stock as a sign that a company is stable or a lower price as a good deal on an investment. The value of a company can’t be judged by its stock price alone. Market capitalization is the right way to look at things because it shows the true value as seen by the market as a whole.
As of Q2 2022, Microsoft, whose stock price was around $300 per share, had a market capitalization of $2.3 trillion, whilst also Berkshire Hathaway (BRK.A), whose stock price was over $50,000 per share, had a market capitalization of $761 billion. If you only looked at the stock prices of the two companies, you wouldn’t get a good idea of how they really compare.
Formula and Calculation
The formula for market capitalization is:
Market Cap = Price Per Share × Shares Outstanding
For illustration, if ABC Corp. exchanges at $30 per share and has a total of 1 million shares in circulation, its capitalization would be $30 million ($30 x 1 million shares).
Since the price of a company’s shares on the market changes every second, the market capitalization also changes all the time. Over time, the number of shares that are still out there can also change.
Note that the number of outstanding shares doesn’t change very often. It only changes when the company does things like issue more shares through a secondary offering, let employees use their employee stock options (ESO), issue or buy back other financial instruments, or buy back its own shares through a share repurchase program.
Changes in market capitalization are mostly caused by changes in share prices, but investors should also keep an eye on things that happen at the corporate level because they can sometimes change the number of outstanding shares.
Competitor Market Capacity Constraints
Values reported by the market cap conceal the true financial situation. That rules out using market capitalization as the only metric by which to evaluate a company before making a crucial choice. The enterprise value, which accounts for a company’s potential acquisition price, is a more appropriate metric to use. The sum of all debt is included in the enterprise value. The net takeover price is calculated by subtracting the cash and short-term investments from the enterprise value. In the event of a merger or acquisition, market capitalization is an inadequate measure of value.
In market-weighted indexes, lower-priced equities will typically be underweighted. Consider it a challenge. The method offers benefits. Passive investing may save money and boost results. Second, although many stocks become worthless over time, indexing, which is based on market size, limits exposure to failing corporations while enhancing exposure to growing ones. It’s easy to understand and utilize indexing. Following an index with market-cap weights is risky.
Taking Into Account Particulars
Reports of a huge corporation moving into a mid- or small-cap firm’s market sector may be devastating to the value of the latter. For instance, Amazon’s foray into cloud hosting providers underneath the Amazon Web Services (AWS) banner has been a major challenge to specialized firms.
Mega-cap or large-cap equities, as opposed to small-cap stocks, are often seen as safer, less volatile investments. The low resources of mid and small-cap firms make their stocks more vulnerable to competition, uncertainty, and business or economic slump, but they can provide high return potential to threaten investors.
There are a wide range of market indexes that may be established using market capitalization information. The S&P 500, a popular stock index, tracks the performance of the 500 largest publicly traded firms in the United States and is weighted by market capitalization, while the FTSE 100 follows the 100 largest companies traded on the London Stock Exchange.
An investor could find market capitalization helpful while researching companies and tracking stock prices. Market capitalization is an easy approach to determine the value of a publicly traded firm by extrapolating the market’s valuation of the company. Instead of using information about a company’s revenue or total assets, investors use this figure. When considering a potential purchase, the market capitalization is utilized to determine the worth of the target.