"Market capitalization" (or market cap) is a fairly common financial phrase. You may have seen stocks or mutual funds described as small-cap, mid-cap or large-cap on financial news websites. Or you may have read newspaper headlines referring to the market cap of a particular company, industry or region. But what does market cap mean? What does it measure? And why is it important to know the market cap of a particular investment, firm or region?
Market capitalization (market cap) is a measurement of the size of a firm. It is the current share price times the number of outstanding shares. For example, a firm with a stock price of $5 dollars a share and 5 million shares outstanding would have a market cap of $25 million dollars. Market cap can also be used to refer to the economic health of a region or a country. The formula for the market cap of a region or a country can be found by adding up the market caps of all firms in the region or the country.
Market Cap Categories
Market capitalization is usually divided into several categories. There is little consensus as to exact figures. Investopedia defines them as: • Nano cap: up to $50 million • Micro cap: $50 million to $300 million • Small cap: $300 million to $2 billion • Mid cap: $2 billion to $10 billion • Large cap: $10 billion to $200 billion • Mega cap: more than $200 billion By contrast, Webster’s New World Finance and Investment Dictionary defines them as: • Micro cap: up to $300 million • Small cap: $300 million to $1 billion • Mid cap: $1 billion to $5 billion • Large cap: more than $5 billion These values will change as time passes and inflation diminishes purchasing power. For example, $1 billion was considered a large market cap in the 1980s.
Market Cap and Stock Indexing
A stock market index is a method of measuring how a particular segment of the stock market is performing. Many indexes track stocks by market cap. The S & P 500 is what is known as a capitalization-weighted index, which means that the firms in the index are weighted according to their market capitalization. If a large-cap stock's price drops precipitously while a small-cap stock's price rises, and the net impact is that the sector of the market containing both stocks drops significantly, the index tracking that sector should be weighted so as to offer proportional performance.
Market Cap and Mutual Funds
Market cap is commonly used by asset managers to determine the types of equities in which they will invest. Many of the most prominent mutual fund families, such as Vanguard, Fidelity, Charles Schwab and T. Rowe Price, offer mutual funds to investors that invest solely in firms of a particular market cap. For example, Vanguard offers multiple small-cap funds, such as the Vanguard Small-Cap Value Index Fund, which tracks an index that measures the equities of value-oriented firms with small market caps.
Factors to Consider
The stock price of a firm is subject to macroeconomic factors that could have a disproportionate impact on the stock price and therefore the market cap. For example, in a recession, a financially healthy firm may see its share price depressed by investors concerned with the health of the entire economy, rather than the firm in particular. Conversely, during an economic bubble, the market cap of an unhealthy firm may indicate that a firm is worth more than it actually is, due to speculative activity. In these circumstances, other means of stock valuation should be employed.
Market cap should rarely, if ever, be used in isolation when determining the intrinsic worth of a firm and its prospects. It provides a snapshot of the size and worth of the firm, but out of context to its liabilities, projected net income, macroeconomic trends and other factors, it is of little value.