Introduction to Market Capitalization

The value of total outstanding shares of a company calculated at the current market price is known as market capitalization, and it is a measure of market sentiment towards the company stock because the market price is determined by the forces of demand and supply and therefore the stock with a higher market capitalization is highly sought after.

Explanation

There is par value of the stock of the company, which is also known as the book value, while there is an issue price, which includes the premium or discount over the par value. However, there is a market price of the stock which is arrived at due to secondary market trading in the stock exchange. It is this price, which is used to calculate the market price.

The total number of outstanding shares includes the closely held shares which are not freely traded on the market such as those held by the promoters or directors of the company. It is commonly abbreviated as ‘Market Cap’

Characteristics of Market Capitalization

There are three categories of Market cap and the method of categorizing different stocks in these categories varies from one market to another and also from one index to another within the same financial market. According to Fidelity, following are the characteristics of the categories below, however, this is not the only way of categorizing the stocks:

1. Large Cap

Stocks with market Cap of $10 billion or more fall under this category, and are considered to be the best in their respective industries. When the market is booming, these companies are the highest grosser, while when the market is bearish, these feel the least heat and therefore fall less than other stocks. Therefore these are safer stocks in the market with lower volatility.

2. Mid Cap

Stocks with market Cap of $2 billion to $10 billion fall under this category. These stocks are riskier than large cap stocks and are relatively new players in the market but they have had their fair share of profitability and are now considered good investments for smaller investors who can’t afford to buy the large cap stocks. These stocks are constantly gaining dominance and are expected to give stiff competition to large cap in times to come.

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3. Small Cap

Stocks with a market Cap of $2 billion or less fall under this category. These are the riskiest of the three and provide high risk high return investment profile. In contrast with the large cap, when the market is booming, these stocks can gain only to a certain extent but when the market is bearish, these are most affected. These are generally invested in by speculators who are betting on their innovativeness and upcoming growth prospects.

There are more categories emerging every now and then such as ‘Microcap’, ‘Nano Cap’, ‘Mega cap’, and so on. Even SEC doesn’t give any strict guidelines of how to categorise market cap.

Formula

Below is the formula for market capitalization.

Market Capitalization = Number of Shares Outstanding * Market Price

The price considered here could be the closing price of that particular day or can be an average of the closing price for a given period of time. It is up to the analyst to see which measure of price is a better indicator of the price-range within which the stock moves.

Example of Market Capitalization

Suppose we have the following information for the stock of company CBA:

Solution:

So assuming that the entire issue price has been paid by the investors, the paid in capital is 2 x 20= $40 million

However, the market cap of the stock is 2 x 25 = $ 50 million

Therefore market cap suggest that the value of the share is greater than the issue price and therefore it has a high demand in the market.

Factors Affecting Market Capitalization

Factors affecting market capitalization are:

Treasury Stock: Those shares which can be issued as an outcome of exercising stock options or warrants and those from the conversion of convertible securities can lead to an increase or decrease in the number of stocks outstanding because even if the proceeds from these is used to repurchase the existing stock, there might be a difference in the number of stock the proceeds can buy at the market price because the option price is not always the same.
Bonus Issue: Bonus shares are issued free of cost and therefore can increase the number of shares outstanding.
Price Movement: Naturally this is the other component of the calculation if the first one is the number of shares outstanding, so price movements affect the market cap.

Advantages and Disadvantages of Market Capitalization

Below are the advantages and disadvantages of Market Capitalization:

Advantages

Some of the advantages are given below:

Index Weighting: It is a popular method of index weighting and is also known as a value weighting scheme. Others are price weighting or equal weighting, which are a little misleading because index values get concentrated to higher priced stocks, which may not be performing well on other indicators such as volume and in case of equal weighted indices, those with higher performance are given equal weight to low performing stocks.
Performance Metric: Market price says a lot about the stock. Those stock which have a price higher than the par value or the issue price and highly sought after stock and therefore attract positive investor sentiment. In the long term, a stock sustaining high price is an outcome of its high profitability which attracts a large number of investors to it.

Disadvantages

Some of the disadvantages are given below:

Closely Held Stock: Those shares which do not trade freely in the market are also included in the calculation and therefore, the market cap can be misleading if the proportion of such shares is very high in the total shareholding. To avoid such problems, a free float market capitalization is used.
Price Subjectivity: As mentioned previously, the price component can vary from one analyst to another, some may take the closing price, some may take the average price while some others may take yet another measure. Therefore, understanding the price component is important while comparing the market cap of two stocks or analysts.

Conclusion

Market cap is a measure of the value of the stock at the current market price and therefore incorporates the investor sentiment into the value of the stock. It is a popular measure and very simple to calculate, however, its one of the biggest flaws is that it included those shares also which are not freely traded in the market, and therefore it can be a misleading measure. To avoid this, most indices use free float in the calculation of market cap.