What is market capitalization?
How to calculate market capitalization, and how to interpret market cap?
In this video, we start off with the definition of market capitalization, we go through an
example of calculating market capitalization, discuss grouping companies by size of market
cap, dive into the meaning of companies having a low market cap or high market cap, and discuss
how market capitalization relates to takeover bids.
The definition of market capitalization.
Market capitalization (or in short: market cap) is the market value of a company based
on the total value of all its publicly traded outstanding shares.
This implies that you cannot calculate a market capitalization for companies that are not
publicly listed.
The formula for calculating market cap is simply to take the number of outstanding shares
and multiply it by the share price.
Let’s take an example of calculating market capitalization.
We will calculate the market cap of Microsoft on November 13, 2018.
The number of outstanding shares can be found in the latest quarterly earnings release,
more specifically at the bottom of the income statement that is included in the press release.
A company discloses its number of outstanding shares in order to give background information
on the Earnings Per Share calculation.
In the case of Microsoft, the weighted average number of outstanding shares for the three
months ended September 30, 2018 was close to 7.7 billion shares.
The second datapoint we need is the share price.
The closing share price for Microsoft on November 13, 2018, was almost $107 per share.
To calculate market capitalization, all we need to do is to multiply the number of outstanding
shares by the share price.
In the case of Microsoft, on November 13, 2018, the market cap was $821 billion, which
on that date makes it one of the three biggest companies in the world
in terms of market capitalization.
There’s an easy way to check whether our calculation of market capitalization is correct:
go to any website or search engine that provides share price information, type in the company
name or ticker symbol, and scroll down below the graph.
Market capitalization tends to be mentioned right there.
$821 billion of market capitalization, just like the outcome of our formula.
Which categories of market capitalization exist?
There is no standard or official definition of market cap categories, but an often used classification
is for small cap companies to have a market capitalization between $300 million and $2 billion,
mid cap or medium cap companies to have a market capitalization between $2 billion and $10 billion,
and large cap companies to have a market capitalization bigger than $10 billion.
Is there anything bigger than a large cap company?
Yes, mega cap companies, with a market capitalization of more than $100 billion.
Is there anything smaller than a small cap company?
Yes, a micro cap company with a market capitalization between $50 million and $300 million, and
even smaller than that, nano cap companies with a market capitalization below $50 million.
So what does having a low market capitalization or a high market capitalization mean?
That is an interesting question, but potentially not the best question to ask, because the
growth or decline in market capitalization might be just as important as the absolute
market capitalization of a company at a point in time.
Here’s a graph of the development of Microsoft’s market capitalization over more than a decade.
In November 2018, with the benefit of hindsight, I sure wish I could travel back in time 3
or 5 years to buy Microsoft shares at $40.
Will I still feel the same in November 2019, November 2020, or November 2021?
Time will tell whether market cap continues to go up, or will move down!
Hindsight is a great thing, and your guess of future market cap is as good (or as poor) as mine.
If we do want to ruminate or speculate on low market cap versus high market cap, then
here are some potential reasons for companies to have a low versus a high market cap.
Low market cap companies tend to have no track record of impressive financial results (yet),
or may have declining financial results.
Many high market cap companies do have a track record of impressive financial results.
A low market capitalization could be a sign of investor pessimism about the company’s
future, and a high market capitalization a sign of optimism.
The share price of a company, and therefore its market capitalization is to a large extent
dependent on expectations for the future.
A low market cap company might have low growth (or even declining) projections for future
revenue, income, and cash flow.
A high market cap company may have higher growth projections.
Besides expectations for the future, a share price (and therefore the market capitalization)
also depends on sentiment: is there low or high excitement about a company’s strategy,
technology and leadership?
Lastly, the development phase that a company and its business units are in, could also
be important.
A low market cap company could be a company in the embryonic or early growth stage with
best yet to come, or a company in decline with its best days behind it, or a company
that will forever stay small.
A high market company could be a company that has reached a certain level of maturity (a
proven track record) in some business units, but has continued exciting new growth opportunities.
Keep those thoughts in mind when making investment decisions, and just like diversifying your
portfolio across industries could help you balance risk and opportunities,
diversifying between holding shares in small cap and large cap companies
could improve diversification as well.
To close off: what is the relationship between market capitalization and takeover bids.
First observation: micro cap, small cap and medium cap companies tend to be the ones that
are most often targeted with a takeover bid.
They are sizable enough to make a contribution to the acquiring company’s inorganic growth
(its growth through acquisition), but not too big to be very risky to integrate.
In other words: companies in this range of market capitalization are big enough to matter,
but not necessarily so large that they could bring down the whole of the newly combined
company in case the merger does not go well.
Remember that market capitalization (or: market cap) is the current market value of a company
based on the total value of all its publicly traded outstanding shares.
In case of a takeover bid, there tends to be an M&A premium of around 20 to 30% on top
of the current share price.
After all, you want to give the current shareholders a good reason to sell their shares to you
and support the takeover.
I hope you enjoyed this explanation and discussion of market capitalization.
We started off with the definition of market capitalization, went through an example of
calculating market capitalization, discussed grouping companies by size of market cap,
dove into the meaning of companies having a low market cap or high market cap, and discussed
how market capitalization relates to takeover bids.
If you enjoyed this video, then please give it a thumbs up!
On this end screen, there are a few suggestions of related videos you can watch next.
Please subscribe to the Finance Storyteller YouTube channel!
Thank you.