Market Capitalisation: A Common Misconception
Updated: Feb 6, 2022
Market capitalisation is a relatively simple, yet often misunderstood concept amongst private investors. It is a key concept for any investor to master, and failing to do so can lead to bad decision-making.
Put simply, market cap is the aggregate market value of a company's shares or cryptocurrency coins/tokens in issue at a given time.
You'd think so, but yet so many private investors continue to miscalculate market capitalisation as they do not account for the total supply of a publicly-listed stock or cryptocurrency coins/tokens in issue - they often forget to include the elements that are 'locked up' or not freely available to be traded without restriction.
But these elements still exist and therefore have a value, and must be considered as part of the calculation.
Calculating Market Cap
Using company ABC Plc as an example: the market cap of ABC Plc is calculated by multiplying its outstanding shares by the current market price of one share.
Since a company is represented by X number of outstanding shares, multiplying X with the market price per share theoretically calculates the total value of the company based on the market's perceived valuation of that company.
IMPORTANT: 'Outstanding' shares refer to a company's stock currently held by all its shareholders, including shares held by institutional investors and restricted shares owned by the company’s officers and insiders. For cryptocurrencies this can also include coins/tokens that are currently restricted in some way, such as the XRP supply which is currently bound by escrow contracts. Sometimes market data providers refer to 'circulating supply', which is often used as a way of stripping out 'locked up' supply, but should not be confused as part of a true market cap calculation.
Market Cap = Current Market Price (per share) x Total Number of Outstanding Shares
Continuing our example above, if ABC Plc was trading at £30 per share on the London Stock Exchange and it had a total outstanding supply of 1 million shares, then its market capitalisation would be (£30 x 1 million shares) = £30 million.
Since the market price of shares in a publicly-listed company changes with each passing second, the market cap also fluctuates accordingly. The number of outstanding shares can also change over time. However, changes to the number of outstanding shares are infrequent, and will only impact the market cap figure when the company goes for certain corporate actions - such as issuing additional shares, exercising employee stock options, issuing/redeeming other financial instruments, or buying back its shares under a share repurchase program.
More often than not, changes in market cap are largely attributed to the share price increasing or decreasing due to the forces of supply and demand, though investors should keep an eye on corporate-level developments that may change the number of outstanding shares once in a while.
Sizing It Up: Different Types of Market Capitalisation
Since market capitalisation represents a value that can vary widely (from a few thousand to above a trillion), different buckets and associated nomenclatures exist for categorising the different market cap ranges.
It is for this reason why market cap is such as fundamental concept for investors to master; the market cap of a stock, or even a cryptocurrency (even though still relatively immature) provides a basic risk profile indicator for a given asset.
The general rule of thumb is that those assets with a high market cap are typically more stable, mature and low-risk. Those with a low market cap are often fledgling companies with high potential for capital appreciation, but represent a higher risk to your initial investment.
The following are the commonly used standards for each capitalisation:
This category includes companies that have a market cap of $300 billion or higher. They are the largest publicly traded companies by market value, and typically represent the leaders of a particular industry sector or market. A limited number of companies qualify for this category. For example, in October 2018, technology leader Apple Inc. (AAPL) reached a market cap of $1.045 trillion, while the online retail giant Amazon Inc. (AMZN) hit $856 billion.
Companies in this category have a market cap between $10 billion to $300 billion. Some high profile examples from the US markets include the major retailer Walmart Inc. (WMT), International Business Machines Corp. (IBM), and General Electric Co. (GE).
Both mega and large cap stocks are referred to as 'blue chips', and are considered to be relatively stable, with low-risk profiles. However, there is no guarantee of these companies maintaining their stable valuations as all businesses are subject to market risks. For instance, during 2018, the valuation of GE tanked by around 45 percent, while that of Apple rose by around 38 percent.
Ranging from $2 billion to $10 billion worth of market cap, this group of companies is considered to be more volatile than the large cap and mega cap companies. Growth stocks represent a significant portion of the mid caps. Some of the companies might not be industry leaders, but they may be on their way to becoming one.
Small cap companies have a market cap between $300 million to $2 billion. While the bulk of this category is comprised of relatively young companies that may have promising growth potential, a few established old businesses which may have lost value in recent times for a variety of reasons also figure in the list. Examples include Bed Bath & Beyond Inc. (BBBY), and OPKO Health Inc. (OPK). The track records of these companies isn’t as lengthy as those of the mid to mega caps, they present the possibility of greater capital appreciation at the cost of greater risk to the investor.
Mainly consisting of "penny stocks", this category denotes companies with market capitalisations between $50 million to $300 million. For instance, a lesser-known pharma company with no marketable product and working on developing a drug for an incurable disease, or a 5-people small company working on artificial intelligence (AI)-powered robotics technology may be listed with small valuation and limited trading activity. While the upward potential of such companies is high if they succeed in hitting the bull’s eye, the downside potential is equally worse if they completely fail. Investments in such companies may not be for the faint-hearted as they do not offer the safest investment, and a great deal of research should be done before entering into such a position.
Adding another high-risk, high-reward layer beyond the micro caps, the companies having market caps below $50 million are classified as nano caps. These companies are considered to be the most risky lot, and the potential for gain varies widely.
Historical analysis reveals that mega and large caps often experience slower growth with lower risk, while small caps have higher growth potential, but come with higher risk. It is common to see companies making transitions from one category to the other depending upon the change in their market cap valuations on a regular basis.
Along with companies, other popular investments like mutual funds and exchange-traded funds (ETF) are also categorised as small cap, mid cap or large cap. In the case of funds, the terms represent the types of stocks the fund invests in.
Market Capitalisation: why does it matter?
Many traders and investors, mostly the novice, often mistake the market price to be a representation of the company’s valuation, health and stability. They may perceive a higher stock price as a measure of a company’s stability, or a lower price as an investment available at a bargain. Stock price alone does not represent a company's actual worth. Market capitalisation is the correct measure to look at, as it represents the true value as perceived by the overall market.
For instance, Microsoft with a stock price of $101.16 per share has a market cap of $814 billion, while IBM with a higher stock price of $142.69 had a lower market cap of $130 billion. Comparing the two companies by solely looking at their stock prices does not give true representation of their actual value.
With billions of dollar worth of valuation, a mega cap or large cap company may have more room to invest a few hundred millions in a new stream of business and may not take a big hit if the venture fails. However, a mid cap or micro cap company making a similar value investment may be susceptible to big blows if their venture fails as they don’t have that bigger cushion to absorb the failure.
If the venture succeeds for large cap companies, it may appear small on their profit numbers. But if the company scales up on the success, it can lead to profits of larger magnitudes. On the other hand, success of such ventures for a mid cap company can bolster its valuations to significant heights.
Valuations of mid cap or small cap companies often take the hit when there are reports of a large cap company invading into their space of products or services. For instance, entry of Amazon into cloud hosting services under the Amazon Web Services (AWS) umbrella has been posing a big threat to smaller companies operating in the niche space.
Generally, investments in mega cap or large cap stocks are considered more conservative than the investments in mid cap or small cap stocks. Though mid and small cap stocks offer high return potential to risk-taking investors, the relatively limited resources at the disposal of such companies makes their stocks more susceptible to competition, uncertainties, and business or economic downturn.
Size Does Matter
Sorry guys, it does appear that “size does matter” (in the context of investing at least). So it's best not to get caught short.
An understanding of the market cap concept is important for not only the individual stock or cryptocurrency investor, but also investors of various funds. The market cap can help the investor to know where they are putting their hard earned money.
Understanding a concept like market cap is an important tool to have at your disposal when picking potential investments. Without it, it will be like fumbling around in the dark and strays more into the territory of pure gambling rather than educated risk-taking.