Market Capitalization

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Definition of Market Capitalization:

A company’s market capitalization (also referred to as the market cap) is the total market value of all the outstanding shares of a company's stock at a given moment. It is calculated by multiplying the number of outstanding shares by the market price per share. 

Detailed Explanation:

Assume you managed a large company and were interested in acquiring ABC, Inc. How much would you pay for ABC, Inc.? A good place to start is ABC, Inc.’s market capitalization (also known as market cap). In other words, the amount you would pay if you purchased every share of stock at the current market price. For example, if a share of Todd’s Sports Equipment sells for $20, and 1 million shares are outstanding, Todd’s Sports Equipment market capitalization equals $20 million. A company’s market capitalization increases following an appreciation of the share price or when the company issues new shares of stock. However, a stock split does not increase it because the share price is adjusted. For example, if Todd’s Sports Equipment has a two-for-one stock split, after the split there would be 2 million shares outstanding, but the price per share would be adjusted to $10. The company’s market cap would remain unchanged at $20 million.

Companies and mutual funds are frequently called large-cap, mid-cap, or small cap. “Cap” refers to the company’s capitalization. Large-cap companies are generally companies with a market capitalization exceeding $10 billion. These are typically large, well-established companies that pay high dividends, and they are leaders in their industries. Normally, investments in large-cap companies are more conservative. Mid-cap companies have a capitalization between $2 and $10 billion. Frequently these companies are in growth industries and offer more potential for growth, but are riskier than large-cap stocks and typically pay a lower dividend. Finally, small-cap companies have a market cap between $300 million and $2 billion. These companies may be in the early growth stage. They are speculative, but they also have a high potential return. Few are household names, and many may struggle to secure the financing they need. Small-cap stocks are normally not recommended for inexperienced investors because of their risk.

Is a company with an $80 share price, less valuable than a company with a share price of $150? Inexperienced investors frequently have the misconception that the price of a share of stock is an indicator of the company’s value and larger companies have shares that are priced higher than smaller companies. This is not true because the number of outstanding shares differs. Market capitalization is a better measure of a company’s size than its stock price. For example, Exxon Mobil is one of the largest companies in the world. On July 7, 2017, its share price equaled $80. At the same time, IPG Photonics sold for $150.30 per share. No one could argue that IPG Photonics was a larger company than Exxon Mobil because its share price was higher. Exxon’s market cap equaled $339 billion, while IPG’s market cap equaled $8.1 billion. Exxon Mobil has a higher market capitalization because it has many more shares outstanding than IPG. 

Market capitalization can be a poor measure of a company's size. For example, on April 4, 2017, the market cap of Tesla ($52.7 billion) exceeded GM's ($49.6 billion), yet in 2016 Tesla produced 83,922 cars (Tesla press release) compared to GM’s 9.9 million cars and light trucks. (Statista)  While investors may argue that the market value of Tesla is higher than GM, few would argue that Tesla is larger than GM. GM has approximately 10 times the assets and net worth that Tesla has. Tesla is valued more than GM because investors believe its potential for future growth is greater.

However, Tesla is not a typical large-cap stock. It was established in 2003 and does not pay a dividend. The company has never earned a profit (as of 2016) and produces relatively few cars. Occasionally, large-cap stocks can be very speculative following investor excitement and a rapid appreciation of the stock price. Investors bid up Tesla's stock price because the company has emerged as a leader in innovation in the automotive industry by building electrical cars that are fun to drive, attractive to look at, and with the most advanced self-driving technology. The bottom line is, market capitalization is a measure of a company’s market value at a given moment. Value is one measure of size and should be considered along with assets, sales, and net worth when measuring the size of a company. 

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