What Is Market Cap and Why Is It Important?

3 Types of Market Cap

Apple iPhone 5C
The new iPhone 5C is displayed inside Apple's store in Causeway Bay district on September 20, 2013 in Hong Kong, China. Photo by Lam Yik Fei/Getty Images

Definition: Market capitalization is the total value of a company. It's measured by the stock price times the number of shares issued. For example, a company that has 1 million shares that are selling for $10 each would have a market capitalization of $10 million. This means you could buy that company for $10 million, if you had the money and all the current stockholders were willing to sell you their shares.

Market capitalization is usually called market cap for short. It also refers to the total value of a stock exchange. For example, the market cap of the NASDAQ would equal the market cap of all the companies traded on the NASDAQ combined.

Small, Medium and Large Cap

Investors use market cap to divide the stock market into three size categories.

Small cap companies have a market cap of less than $1 billion. They are smaller companies, many of which recently went through their Initial Public Offering, or IPO. They are riskier, because they are more likely to default during a downturn. On the other hand, they have lots of room to grow, and could become very profitable.

Mid cap companies are less risky, but may not have the same potential for growth. They typically have a capitalization of between $1 billion to $5 billion. A recent study showed they actually outperformed both small cap and large cap stocks over the last 20 years.

Large cap companies have the least risk, because they typically have the financial resources to weather a downturn. Since they tend to be market leaders, they also have less room to grow. Therefore, the return may not be as high as small or mid cap stocks. On the other hand, they are more likely to reward stockholders with dividends.

The market cap for these companies is $5 billion or more.

Is Market Cap a Good Way to Value Companies?

Market cap is a relatively good way to quickly value a company. That's because stock prices are generally based on investors' expectations of a company's earnings. As earnings rise, stock traders will bid more for the stock price. Including the number of shares in the calculation offsets the impact of stock splits.

Market cap would be a great way to value companies if they all had the same price to earnings ratio. However, some industries are seen as slow growing or stodgy. Their stock prices are undervalued, and so are the market caps of companies in that industry.

There are several other ways to determine the value of a company. One good way is to determine the net present value of its future cash flow, or income. This gives the buyer an idea of what the return on investment will be. If a company's market cap is lower than the net present value of its cash flow, then it is undervalue, and a candidate for takeover.

Another more conservative approach is to determine the total resale price of all a company's assets. The drawback is that some assets would be difficult to value. Others may be worth more than their resale value.

However, this is a good approach for a company that just wants to buy the company and sell off the assets for quick cash. A company whose market cap was much lower than its resale value would be a target for this kind of takeover.

During the "Greed is good" days of Ivan Boesky, many companies were worth much less than their resale value. Conversely, during the Internet bull market in 1999, many companies' capitalization values were worth far more than their income or asset value. Irrational exuberance drove stock prices beyond a reasonable valuation. When the tech bubble burst, it led to the recession of 2001. (New York Times, Confronting a Law of Limits, February 24, 2012)

Largest Companies by Market Cap

In 2012, Apple became the largest company as measured by market cap. Its share price was more than $500 a share, and people wondered how it could grow much more.

Apple built its business by being a technological innovator, and creating brand loyalty by understanding its customer base. Here's a list of the top 20 largest companies by market cap:

  1. Apple - $725 billion
  2. Google - $375 billion.
  3. Exxon Mobil - $357 billion.
  4. Berkshire Hathaway - $357 billion.
  5. Microsoft - $334 billion.
  6. PetroChina - $330 billion.
  7. Wells Fargo - $280 billion.
  8. Johnson & Johnson - $280 billion.
  9. ICBC - $275
  10. Novartis - $224 billion.
  11. China Mobile - $267 billion.
  12. Wal-Mart - $242 billion.
  13. General Electric - $250 billion.
  14. Nestle - $244 billion.
  15. Toyota - $239 billion.
  16. Roche Holding - $237 billion.
  17. Facebook - $231 billion
  18. JPMorgan Chase - $226 billion.
  19. Procter & Gamble - $221 billion.
  20. Pfizer - $214 billion.

Most of these companies are all well-known, household names. Many have been on the top 20 list for years. In fact, only 11 different companies have held the number one slot since 1926. (Source: PWC, Market Capitalization of Top 100 Companies, March 2015)