Definition: Market capitalization is explained as the company’s market value denoted in dollar amount. It is the valuation of a company’s outstanding or publicly traded shares available for exchange in the open market or stock market. However, it cannot be misinterpreted as the overall corporate value.
The market cap determines the risk and returns associated with a company’s stocks. Investors use it as a tool to select shares that help them diversify their portfolio and generate optimum returns.
Factors Affecting Market Capitalization
Market capitalization is influenced by multiple elements, some of these are stated below:
Company-Specific or Market Sensitive News: There are events when the organization gets defamed in the stock market by negative news. The investors start selling off their shares as a result the market cap falls.
Company’s Fundamental Strength: The market valuation of any company is highly influenced by its growth potential, performance, financial position and other parameters.
Bonus Issue: The number of outstanding shares often includes the bonus shares which are given out as complimentary. Therefore, including such shares, while computing market cap, affects its valuation.
External Factors: Some of the extraneous influencers including geographical circumstances, environmental, cultural, social and political factors results in fall or rise in a company’s market cap.
Demand and Supply: The value of a company’s stock varies based on its demand and supply among the investors. With an increase in the company’s stock demand, its price also hikes up and vice-versa.
Price Movement: Whether due to change in profitability or stock demand or any other reason, the price of the shares goes up or down. Thus, increasing or decreasing the market capitalization of the company.
Competitor’s Performance: The competitor’s strategy and market position also impact the company’s earnings and share prices. When the competitor overtakes the market share, the company’s market cap also falls gradually.
Treasury Stock: Some of the security types such as convertible securities, stock options, stock warrants and others when executed results in the variation of the count of outstanding shares and hence the market cap.
Market Capitalization Categories
Market cap is a parameter to understand the risk and return associated with a certain kind of stock.
The market cap of different companies are categorized into the following six types:
Nano-cap comprises of the companies which belong to the extreme risk-high returns category since they have a market capitalization lower than $50 million. The related stocks are exchanged on over the counter bulletin board. For instance; Prime Industries Ltd.
The companies whose market valuation range between $50 million and $300 million belong to the micro-cap category. The potential risk involved in such an investment is quite high. Also, they may provide great returns if everything goes well and vice-versa. For instance; Stein Mart Inc.
The market valuation of the small-cap companies range from $300 million to $2 billion where the risk is still high but the gains are better than that in earlier options. Most of the high potential young companies fall in this category. For instance; Bombay Dyeing
These companies have a market cap between $2 billion and $10 billion and contribute considerably to the growth funds. Thus, they are at the verge of becoming star companies with a lower level of risk involved for the investors. For instance; Adani Power
The large-cap companies frame the big picture where the market capitalization ranges from $10 billion to $200 billion. These are the well-established entities involving minimal risk and providing stable returns; however, the further growth prospective is quite low. For instance; Hindustan Unilever
All those corporates with a market valuation of more than $200 billion come under the mega-cap category. We can say that such companies are the market leaders and involve the least risk. While the returns are quite low since these companies are at the best of what they are doing. For instance; Apple Inc.
Free-Float Market Cap
A float can be defined as the total number of outstanding shares that are freely exchanged in the open market.
Thus, the free-float market capitalization includes all the freely traded outstanding shares except the ones held by the company executives.
Calculation of Market Capitalization
Market capitalization provides the insight of a company’s stock weightage in the share market and its potential return. Given below is the market capitalization formula:
The two elements required for the computation of market capitalization are:
- Number of Shares Outstanding: It is the total number of shares available in the open market, i.e., the stocks held by the public shareholders and promoters except the treasury stocks repurchased by the company.
- Price Per Share: This is the prevailing market price of the stock which is determined by taking into consideration its demand and supply in the open market.
XYZ Ltd. has 1.2 million outstanding shares at a price of $17.5 per share. Find out its market capitalization.
Market Cap = 1200000 x 17.5
Market Cap = $21000000 or $210 million
Hence, we can say that XYZ Ltd. is a micro-cap company.
Importance of Market Capitalization
Market cap can be seen as a useful tool for not only the investors but also for a company and its competitors. Let us discuss its multiple benefits below:
- Facilitates Comparison: An investor compares the market worth of different corporate stocks with the help of their market capitalization.
- Accurate Risk Analysis: Going through the market capitalization changes of a particular stock somewhere warns the investors of the risk involved in such an investment.
- Balanced Portfolio: The investors create a balanced portfolio by including a different kind of stocks varied in terms of their market cap while maintaining a reasonable amount of risk and returns.
- Universally Applicable: In every country of the world, the market capitalization method is widely accepted to evaluate a company’s market value.
- Influences Share Market Index: It is a commonly used tool to analyze the weightage of various companies’ stocks and their position in the market index.
Disadvantages of Market Capitalization
Market cap is sometimes criticized for some of its shortcomings which are as follows:
- Ignores Returns: Market capitalization overlooks the dividend and other forms of returns while computing the company’s market value.
- Price Subjectivity: The stock prices of a company may not be interpreted as same by every analyst, resulting in price variation and inconsistency.
- Neglects Company’s Debt or Liabilities: For the investors, market cap lacks the analysis of the effect of debts and liabilities on a company’s publicly traded shares.
- Closely Held Stock: In the absence of free-float market capitalization, the outstanding shares include some of those stocks which are not freely traded thus, providing improper results.
Market capitalization is the easiest way of determining the growth prospects of any company. Also, it is a popular criterion used by the investors for foreseeing the associated risk and return before buying a corporate stock.