What is Market Capitalization?

The total market capitalization of a listed company allows investors to compare the relative size of one company to another, irrespective of geography. Market capitalization measures a company's value and prospects on the open market, reflecting how much investors are willing to pay for its shares.

This article discusses what market capitalization is in detail.
 

What is Market Capitalization?

Understanding a company's value is significant, and often difficult to identify accurately. Market capitalization means the total number of shares outstanding multiplied by the price per share. It is a quick and easy method of estimating the value of a publicly traded company. 

After a company is listed and traded on a stock exchange, its price is determined by the supply and demand of its shares in the market.  The price rise if the stock is in high demand due to favourable factors. If the company's future growth prospects are unfavourable, sellers may lower the stock price. Market capitalization becomes a real-time estimate of a company's value.
 

How to calculate Market Cap?

You can calculate Market Cap using the below formula.

MC = N x P

Where MC means market capital

N stands for the number of outstanding shares.

And P is the closing price of the concerned company’s shares.

For example, if a company has 50,000 outstanding equity shares, with a closing price of INR 75 per share, now the company’s total market cap would be calculated as

MC = N x P

= 50,000 x INR 75

= INR 27,50,000 

Therefore, the total value of the company is INR 27,50,000.
 

Importance of Market Capitalization

The market cap plays a crucial role In understanding a stock’s potential. The importance of market cap includes

1.  Global metrics: Market cap is widely used to evaluate a stock. Since it is a globally accepted method, it is easier for investors to compare the stocks irrespective of their geographic or economic differences.

2.  Precise suggestions: Any suggestions on market conditions may be risky due to various factors involved in making the said suggestion. However, the market cap method is very precise in its evaluation. It fairly suggests the risks associated with a company.

3.  Affects the index: This method is also used to weigh the stocks of various companies for stock market indices. Under this method, stocks with higher market capitalization are weighted more heavily in the index.

4.  Useful for comparison: It is a convenient way for investors to compare different companies as it is a universal method used to assess the market value of any company. This comparison not only helps you understand the size of the company but also the risks involved in investing in the company.

5.  Balanced Portfolio: Investors should keep a balanced portfolio to avoid risks of greater losses. A balanced portfolio generally includes investing in some of the top companies through market capitalization and risky investments in developing companies. 

While this valuation process is convenient and widely accepted, investors should also be aware that it excludes company and other financial liabilities. Consider different types of returns such as stock splits, dividends, etc.
 

Types of Market Capitalization

An investor can select from three different sorts of stocks based on this widely used approach of analyzing a firm. Risk may be reduced by distributing the portfolio among all of these in a sensible way.

Market Cap exceeding Rs. 20,000 crore designates a company as a Mega-Cap Stock. The three main stock categories that investors choose to pursue are covered in more detail below.

Types of Companies Based on Market Cap

1. Large-cap: These are among of the market's most reliable company groupings. Therefore, the least hazardous course of action is to invest in these businesses. But it's also crucial to remember that because they are solid businesses, the return on investment is generally modest.
These businesses have usually achieved the peak of their development, thus there is less likelihood of a significant shift in stock price. Nonetheless, buying these companies is a prudent choice due to the low risk and less aggressive growth.

2. Mid-cap: Based on market capitalization, this category includes companies with significant growth potential that have had some stability and growth. These stocks show the potential for future growth together with a company's degree of industry establishment.
Since these businesses are still relatively new to the market, investing in their stocks carries a somewhat lower risk than that of the next set of firms, but it is still dangerous. They may thus yield a return that is larger than that of large-cap equities.

3. Small-cap: The riskiest equities are those that comprise firms with the smallest market capitalization. These are emerging businesses that have not yet made a name for themselves in their sector. They are therefore quite dangerous. When a company succeeds, its stock price may soar, but when it fails, its stockholders may suffer a significant loss. The most daring investing choices are these.
 

Market Cap Vs. Share Holder's Equity

Market capitalization & shareholder equity are important metrics for assessing not only company's value but also financial health, but they differ ways: 

1. Meaning: Market cap is total market value of company's outstanding shares, whereas shareholder equity is company's net worth from accounting perspective. 

2. Calculation: Market cap is calculated by multiplying total number of outstanding shares by market price of single share. Shareholder equity is calculated by subtracting company's liabilities from its assets. 

3. Fluctuation: Market cap fluctuates based on not only stock prices but also investor sentiment, while shareholder equity is more stable. 

4. Purpose: Market cap is quick way for investors to categorize companies by size, while equity provides insight into not only company's financial health but also value available to shareholders. 

5. Risk: Stocks with larger market cap are often considered less risky, but this isn't always case. For instance, large-cap stock with lot of debt or bad news may be riskier than expected, while small-cap stock with not only steady earnings but also little debt may be less risky.
 

Market Capitalization investment strategy

Given the simplicity and effectiveness of risk assessment, market capitalization can be a useful metric to decide which stocks to invest in and how to diversify a portfolio with companies of various sizes.

Large-cap companies (also known as big-cap companies) typically have a market capitalization of $10 billion or more. These companies have been around for a long time and are major players in established industries. Investing in large-cap stocks doesn't necessarily yield big returns in the short term. Regardless, these companies typically reward investors with consistent stock appreciation and dividend payments over the long run. Examples of large-cap stocks include Reliance Industries, Tata Group, etc.

Mid-cap companies typically have market caps between $2 billion and $10 billion. Medium-sized companies are established in their operating industries and are expected to grow rapidly. They are inherently more risky than large-cap companies because they are comparatively less established than the big companies, but they are attractive because of their growth potential. An example of a medium-sized company is Relaxo Footwear.

Companies with market caps between $300 million and $2 billion are typically classified as small caps. These small businesses may be young companies or serve niche markets or new industries. These companies are considered riskier investments because of their age, the markets they serve, and their size.

Smaller businesses with fewer resources are more sensitive to economic downturns. As a result, small-cap stock prices tend to be more volatile and less liquid than larger, more mature companies. Similarly, small businesses often offer greater growth opportunities than large companies. Even smaller companies are known as microcaps, which range in value from about $50 million to $300 million.
 

What are the factors which impact Market Caps?

There are several factors affecting the market cap including:

●  Both the demand for an institution's products or services and its ability to meet that need.
●  Exercise of warrants against company stock may reduce its value.
●  Performance and ingenuity of competing brands or institutions.
●  Company credibility and reputation.

A company's outstanding shares vary depending on share buybacks and stock buybacks. A stock split to issue new shares does not change the company's market capitalization. While various factors impact MC, it is prudent for investors to do the same.

Here is an example. Given that a company's shares are priced at Rs 100 if Ms Mehra invests Rs 10,000, he will get 100 shares of the company. The stock price will be positively affected if the company's market capitalization increases. When the stock price rises to Rs. 120, Mehra’s total investment is Rs 12,000. As a result, Ms Mehra makes a profit of Rs.2,000 with an initial investment of Rs. 10,000.
 

Other Ways of Evaluating a Company’s Value

Investors should familiarize themselves with a few pertinent ratios that are useful while studying market capitalization. MC is taken into account in these ratios.

1. Price to earnings ratios: These are used to calculate the projected return on investment for purchasing a company's shares. To get this ratio, divide the MC by the net income for the previous twelve months.
2. Price to Free Cash Flow Ratios: To compute this ratio, divide the 12-month free cash flow (MC) by 12. The projected anticipated returns are likewise projected using it.
3. Cost to Book Value Ratios: This is computed by dividing MC by the entire book value of the business. It is calculated by subtracting the entire amount of an institution's obligations from its total book value of assets.
4. EV to EBITDA: This gauges the short-term operational returns that may be anticipated. Earnings before Interest, Taxes, Depreciation, and Amortization is referred to as EBITDA. After subtracting total cash and adding the market capitalization to the value of preference shares and debentures, enterprise value (EV) is determined. By dividing the EV by EBTIDA, the ratio is computed.

Misconceptions About Market Caps

Market capitalization is a term used to describe a firm, although it is not a measure of a company's equity worth. That can only be accomplished by a careful examination of a business's foundations. The market price simply indicates how much the market is ready to pay for shares since shares are frequently overvalued or undervalued by the market.

The price at which a firm would be acquired in a merger does not depend on its market capitalization. An improved way to figure out how much it would cost to buy a company entirely is to use its enterprise value.
 

Conclusion

When observing stocks and assessing possible investments, market capitalization may be a useful tool for investors. For publicly listed firms, market capitalization provides a quick and simple way to estimate a company's value by extrapolating what the market believes it is worth. The market capitalization of a takeover candidate aids in evaluating whether the acquirer will find the candidate to be a suitable fit.