There are many ways to evaluate a company’s worth, and there’s no one right or wrong way to do so. Market capitalization is just one measurement investors use to guide their investment strategy.
Market capitalization, or market cap, is the price investors use to interpret a company’s value. Joel Salomon, CFA, FSA, and chief prosperity officer of SaLaurMor, explains that it’s the price at which public markets currently value the company. Although it may not tell the complete story of a company’s financial state, it can be used in combination with other factors to gain additional insights.
Calculating market capitalization
Market cap values the company based on the market price of the company’s share of stocks. To arrive at this number, multiply the cost per share by the total number of outstanding shares.
Market capitalization = cost per share x total outstanding shares
For example, if a company has 3 million outstanding shares, and they currently cost $10 each, then the market capitalization would be $30 million ($10 x 3 million).
The cost per share refers to the current market price an investor pays per share. Outstanding shares are the total number of shares investors currently own. These numbers are publicly available online, where you can find real-time stock market quotes.
Interpreting market capitalization
Investors use market cap to make predictions about the future of a company and to guide their investment strategy. It provides a current snapshot of how the stock market values a company, which allows you to compare it to the performance of other companies. You can also use it to decide if you think the value will go up or down based on the fair trade value, Salomon explains.
Market cap can also help determine the company’s size. Some investors place businesses in small-, mid-, and large-cap categories, based on the company’s market cap value. If a company has an extremely high market capitalization value, they are placed in the large-cap category, but if they have a low value, they are placed in the small-cap category.
Investors assume the higher the value, the larger the company. But because there is no standardized price range for each category, investors tend to use these categories only to approximate company size.
Understanding market capitalization limitations
One limitation of using the market cap as the only valuation method is that it provides no relation to what the company is earning, explains Salomon.
If you’re looking at a company with a market cap of $10 billion, “Is that high or low?” Salomon asks. “I don’t know; how much money does it make? If they make a billion dollars, that’s 10 times their earnings; depending on how quickly they are growing, that may be inexpensive.”
Alternatively, if you’re looking at a company with a market cap of $10 billion and $100 million in earnings, “That’s a 100 times earnings, and that’s generally considered expensive,” Salomon says. In this case, looking at a company’s earnings alongside its market cap can help paint the bigger picture.
Another limitation of market cap is that it doesn’t include the company’s debt. To overcome this challenge, many investors prefer to use enterprise value to determine the company’s overall value. This measurement includes market capitalization but also acknowledges other components, such as cash and debt.
Market cap provides valuable insight for investors to make strategic decisions, but experts remind us to consider other key contributors. Using market cap in combination with other formulas and measures can show a more holistic view of a company’s worth.
For more information, review our complete guide on enterprises.