Market Capitalization: How It Works And Its Formula

Market capitalization is a term used to describe the size of a company based on the total value of the company’s stock. Market capitalization is an important data point for making informed investment decisions, managing return expectations and building a well-balanced portfolio.

Knowing the total value of stocks can help investors distinguish between risky and conservative investments, or help them to diversify based on their particular goals. For example, large companies might be more stable with less room for growth in their returns, but might be the right choice for a portfolio with a short time horizon or an investor with a low risk tolerance. Market capitalization, or market cap, provides part of the information to make these decisions.

A company’s market cap can be found by multiplying the current stock price by the total number of outstanding shares. Outstanding shares are shares that have been issued and sold to shareholders, including those held by insiders and institutional investors. The calculation does not include treasury shares, which are shares of the company that it has repurchased.

For example, if Company A had 20 million shares outstanding and a share price of $500, its market cap is as follows:

$500 x 20,000,000 = $10,000,000,000 market capitalization

Again, that’s the price of one share multiplied by the total number of outstanding shares.

So, assuming that Company A has a $10 billion market cap – what does that actually mean? Companies are typically divided into three major categories based on their size:

  • Large-cap: Companies with a market capitalization of $15 billion or more
  • Mid-cap: Companies with a market capitalization between $3 billion and $15 billion
  • Small-cap: Companies with a market capitalization between $300 million and $3 billion

In the example above, Company A with a market cap of $10 billion could be considered a mid-cap.

Sometimes investors classify stocks that are much larger than large-cap as mega-caps, while those smaller than small-cap are sometimes called micro-caps or even nano-caps.

The market cap of a company often says something about the quality of the business underlying the stock as well as how the stock tends to trade.

Large-caps are typically known for being stable companies with robust balance sheets. These companies typically show less volatility during market downturns than their mid-and small-cap counterparts.

Companies with large market capitalizations are some of the biggest companies in business. Companies such as Apple, Microsoft, Alphabet, Amazon and Berkshire Hathaway occupy the large-cap market. Large-cap companies often have reputations for producing quality goods, showing steady growth and are often dominant players within established industries.

“In economic downturns, large-cap companies have historically outperformed relative to their small- and mid-cap counterparts, primarily because they represent more established companies with stronger balance sheets,” says Mark Andraos, associate portfolio manager at Regency Wealth Management in New York.

Smaller companies on the other hand can be a mixed bag. While smaller companies may have more room for growth than large-cap companies, their less established position within their industry and generally weaker balance sheets mean investing in these companies comes with more risk but also more potential return if they succeed.

That said, there is a place for mid- and small-caps in certain portfolios. “In any given industry, there might be a handful of major players. It’s the smaller players where you can sometimes find value,” says Holmes Osborne, principal at Osborne Global Investors in Missouri.

Market capitalization is a fundamental piece of information needed to make investment decisions, and gives a big-picture view of the value of a company. However, market cap can fluctuate greatly day-to-day, especially in smaller companies, as the stock bounces around.

Market cap does not provide any information on a company’s debt profile. Looking at a company based solely on its market capitalization will not provide information on how indebted the company is and the potential risks that come along with that.

Market capitalization can impact how you construct an investment portfolio. Experts generally recommend investment diversification, meaning owning a combination of small-, mid- and large-cap companies.

“To be fully diversified, one generally should be diversified across market capitalization and across value/growth,” says Robert Johnson, CEO and chair at index development and licensing firm Economic Index Associates in New York.

For example, if your goal is large returns, you can focus on small-caps but also invest in some large-cap companies to reduce volatility.

“It is much more likely that one can hit a home run by investing in a small-cap stock, but it is also more likely that a strikeout will occur,” says Johnson.

If your goal leans more toward stability, you can focus on large-caps, but you can also include smaller companies with growth potential to provide some extra juice to the portfolio.

But be careful if you’re adding individual stocks to a portfolio of index funds since you might be adding in extra exposure to companies that you already own.

“Most index funds today are weighted based on market capitalization…. Almost 20 percent of the S&P 500 can be found in technology companies like Apple, Microsoft, Google, Amazon and Tesla, and combining a typical market-weighted approach to investing could over concentrate a portfolio in tech,” says Doug Amis, CEO at Cardinal Retirement Planning in the Chapel Hill, North Carolina area.

Then using your time horizon and risk tolerance as benchmarks, you can build out a diversified selection of investments.

Bottom line

Understanding market capitalization is important when it comes to selecting your investments because it can help evaluate an investment’s total opportunity. However, it does not provide a well-rounded representation of a company’s overall performance and holdings, which investors need to take into account when building their portfolios.

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