Why You Shouldn't Ignore Market Cap When Considering Stocks
When you're evaluating a publicly traded company and deciding whether you want to purchase some of its stock, you shouldn't focus solely on the price of an individual share. Make sure you look at its market capitalization, or market cap, to get a more clear picture of how the market values the company.
The market cap is the share price multiplied by the number of shares outstanding, so it represents the amount you would pay to buy up all of the company's shares, not necessarily its true value. The size of a business's market cap determines which broad category of publicly traded company it falls under: small cap, mid cap, or large cap.
Examples of Market Caps Compared With Stock Prices
Consider these two companies with very different stock prices yet somewhat similar market caps:
- Stock price: $50
- Outstanding shares: 50 million
- Market cap: $50 x 50,000,000 = $2.5 billion
- Stock price: $10
- Outstanding shares: 300 million
- Market cap: $10 x 300,000,000 = $3 billion
If you looked only at their per-share prices, you wouldn't know the second company was the more highly valued of the two.
Free-Float Market Caps
If only shares that are freely traded are considered when calculating the market capitalization, it's called a free-float market cap. This method excludes shares held by company executives, a national government, or some other private entity whose stake is not available for trading on the market. Most stock market indexes, including the Dow Jones Industrial Average and the Standard & Poor's 500 Index, use free-float market caps.
Small, Mid, and Large Caps
When you're evaluating companies, market caps help you compare those of similar sizes. Definitions for small-, mid-, and large-cap companies differ and change as the overall market waxes and wanes, but here is one classification system:
- Small Cap: under $1 billion
- Mid Cap: $1 billion to $10 billion
- Large Cap: $10 billion plus
On February 20, 2019, Standard & Poor's started using the following market-cap limits and ranges for its large-, mid-, and small-cap indexes :
- S&P 500: at least $8.2 billion
- S&P MidCap 400: $2.4 billion to $8.2 billion
- S&P SmallCap 600: $600 million to $2.4 billion
Some firms and analysts add micro caps and mega caps—the absolute smallest and biggest publicly traded companies—to the mix.
Generally speaking, small-cap stocks have greater potential for price growth because the companies themselves still have room to grow but may also be riskier investments because of the uncertainty of the companies' future performance. Large-cap stocks have less potential for price appreciation but are considered to be safer investments because of their longer track record of success. Mid-cap stocks typically fall in between small caps and large caps for those growth and safety parameters.
Market Cap vs. Enterprise Value
A company's market cap can also be referred to as its equity value and takes into consideration only the value of its shares. A broader way of assessing a company's worth is enterprise value.
To calculate a company's enterprise value, you add its market cap to the value of its outstanding preferred shares (if applicable), any minority interest in the company (if applicable), and the market value of its debt and then subtract its cash and equivalents.
The cash and equivalents are subtracted out because if you were to actually buy the company, you would take possession of that money. Therefore, it shouldn't be included when arriving at a theoretical takeover price for the company.
You can use enterprise value instead of market cap in common metrics for evaluating companies, such as price-to-earnings and price-to-sales ratios. Doing so may help you more accurately determine the worth of companies with large cash holdings.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.