Market capitalization is a term used on Wall Street that is extremely important. Although it is often heard on the nightly news and in financial textbooks, very few new investors know what market capitalization is or how it is calculated. It’s actually really easy and intuitive. After you read about the details of market cap, as it is often called for short, you’ll understand the concept and begin using it when putting together your own portfolio.
The Definition of Market Capitalization
Put simply, market capitalization is the amount of money it would cost if you were to buy every single share of stock a company had issued at the current market price. For instance, The Coca-Cola Company has 2,317,441,658 shares of stock outstanding and the stock closed at $49.60 per share. If you wanted to buy every single share of Coca-Cola stock in the world, it would cost you 2,317,441,658 shares x $49.60 = $114,945,106,236.80. That’s just shy of $115 billion. On Wall Street, people would refer to Coca-Cola’s market capitalization as $115 billion.
Why is market capitalization such an important concept? It allows investors to understand the relative size of one company versus another. AutoZone, a retailer of auto parts, trades at $150.31 per share. Yet, the company’s market capitalization is only $8 billion. Despite having a stock price 3x higher than Coke, AutoZone is actually only 6.9% the size of the soft drink giant! This is why I wrote How to Think About Share Price. In that article, you learned that it’s possible for a $300 stock to be cheaper than a $10 stock.
The Shortcomings of Market Capitalization
There are some shortcomings to using market capitalization as a guide to a company’s size. The biggest is that market capitalization does not factor into consideration a company’s debt. In other words, in addition to having $115 billion in stock market value, Coca-Cola has $20 billion in debt. If you were to buy every share of Coke’s stock, you would own the company but still be responsible for the company’s $20 billion in debt. Thus, your “true” purchase price would be $115 billion + $20 billion = $135 billion. This figure is known as enterprise value and I explained everything you need to know about it in the article Enterprise Value – Determining the Takeover Value of a Company. There are actually some other factors that determine the difference between market capitalization and enterprise value so if you’re interested in the details, it would be worth your time to click over to those articles and take a few moments to read them.
Using Market Capitalization to Build a Portfolio
A lot professional investors divide their portfolio by market capitalization size. This approach, they believe, allows them to take advantage of the fact that smaller companies have historically grown faster but larger companies have more stability and pay fatter dividends.
Here is a breakdown of the type of market capitalization categories you are likely to see referenced when you begin investing:
Micro Cap: The term micro cap refers to a company with a market capitalization of less than $300 million.
Small Cap: The term small cap refers to a company with a market capitalization of $300 million to $2 billion.
Mid Cap: The term mid cap refers to a company with a market capitalization of $2 billion to $10 billion.
Large Cap: The term large cap refers to a company with a market capitalization of $10 billion to $50 billion.
Mega Cap: The term mega cap refers to a company with a market capitalization of $50 billion or more.
