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The market cap represents the total value of a company’s shares. It is used to compare the sizes of companies, which helps investors assess risks and potential returns. Learn about the definition of market cap, how it works, and how to use it for making investment decisions.

What is Market Cap?

Simply put, the market cap of a stock is the price you would pay to purchase each share at the current market price. This metric is useful for comparing the size of one company to another.
There are also some benefits and risks associated with investing in companies of certain sizes, so investors may want to focus on a specific company size, such as large-cap companies, or diversify by owning small, mid, and large-cap companies in their portfolio.

How does Market Cap work?

Market cap includes all shares available in the market. It does not include restricted shares, such as those held by company executives. It is also affected by the stock’s value. If the value of a company’s shares decreases, its market cap will decrease. Exercising options can also affect the market cap, as options increase the number of shares available. An option is the right to purchase a certain number of shares at a set price in the future.
Typically, investors base their decisions on earnings and potential growth when investing in stocks. The size of the company plays a role in its ability to grow in the future and the risks of failure. Generally, small companies have more growth opportunities but are riskier since they have not proven themselves. Large companies may not achieve explosive growth, but they are also less likely to fail, even when the economy deteriorates.

How to Calculate Market Cap

The formula to calculate market cap is simple. You only need two pieces of data: the number of outstanding shares and the current market price of the share. Here is the formula:
Total Market Value = Number of Outstanding Shares × Current Market Price
For example, on December 31, 2021, Coca-Cola had about 4.34 billion shares outstanding, and the stock was trading at $59.21 per share. If you wanted to purchase every share in existence for Coca-Cola, it would cost you 4,340,000,000 shares × $59.21, or $256,971,400,000. That’s over $256 billion. On Wall Street, people would refer to Coca-Cola’s market cap as being around $256 billion at the end of 2021.

Benefits of Using Market Cap for Investment

Stock prices can sometimes be misleading when comparing one company to another. On the other hand, market cap ignores the capital structure of companies that may cause one company’s share price to be higher than another. This allows investors to understand the sizes of the two comparable companies.
For example, compare Coca-Cola’s stock at $59.21 per share and Netflix’s streaming service at $602.44 per share at the end of the day on December 31, 2021. Although the latter has a higher share price overall, it has a market cap of about $267 billion, making it compare with Coca-Cola.

Risks of Using Market Cap for Investment

Market cap is limited to what it can tell you. The biggest drawback of this specific metric is that it does not take a company’s debt into consideration. For example, in December 2021, the company had about $20 billion in current liabilities (debt, taxes, etc.). If you wanted to buy the entire operation, you would be responsible for servicing and repaying all these liabilities. While the market cap for Coca-Cola was $256 billion, its enterprise value was $282.9 billion. Similarly, that is the amount you would need to buy all common stock and pay off all the company’s debt as well. The enterprise value is a more accurate measure of determining the acquisition value of a company.
Adding
To that end, the biggest drawback of using market capitalization as an indicator of a company’s performance is that it does not account for distributions such as spin-offs, separations, and dividends, which are crucial in calculating a concept known as total return.
It may seem strange to many new investors, but total return can lead to gains for the investor, even if the company itself goes bankrupt. For example, you may have accumulated dividends over the years. The company can also be acquired, and your shares can be bought or exchanged for shares in the new parent company.

Using Market Capitalization to Build an Investment Portfolio

Many professional investors divide their portfolios according to market capitalization size. They do this because they believe it allows them to take advantage of the fact that smaller companies have historically grown at a faster pace, while larger companies are more stable and pay more dividends.
Below is a breakdown of market capitalization size categories that you may encounter when you start investing.
Small Cap: The term small cap refers to a company with a market capitalization ranging from $300 million to $3 billion. These companies are relatively new and may have a high growth level. They are also more susceptible to competition and economic conditions.
Mid Cap: The term mid cap refers to a company with a market capitalization ranging from $3 billion to $10 billion. These companies are less volatile than small cap companies but riskier than large cap companies.
Large Cap: The term large cap refers to a company with a market capitalization of over $10 billion. These companies are well-known firms and may offer regular dividend payments with a low likelihood of a significant drop in stock price.

Key Takeaways

Market capitalization is the total value of a company’s shares. Multiply the number of outstanding shares by the current market price per share to find the total market value. Market capitalization can provide an approximate estimate of the risks associated with investing in a company and its growth potential. However, it does not include important factors such as the company’s debt.

Source: https://www.thebalancemoney.com/stock-market-capitalization-101-357337


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