Market capitalisation, often referred to as market cap, is a financial term that describes the measurement of the size and value of a company. It represents the total value of a company’s outstanding shares of stock and serves as an indicator of its overall worth in the eyes of investors.
If you’re looking to invest in stocks or evaluate the strength and potential of a business, having a proper grasp on why market cap is really important. That is, exactly what it is, what it represents and why it’s significant in the financial world.
How Do You Calculate Market Cap?
Calculating market capitalisation is actually pretty easy. Essentially, it’s derived by multiplying the total number of a company’s outstanding shares by the current market price of a single share. And, that’s it!
For example, if a company has 10 million shares outstanding and the value of a single share is worth £50, the market cap would be £500 million.
Essentially, this figure gives you a snapshot of a company’s value as perceived by the stock market at a specific moment in time. Now, this is important, because companies’ shares tend to fluctuate constantly due to supply, demand and market sentiment.
Thus, market cap doesn’t reflect a business’s intrinsic value or even financial health necessarily. Rather, it just gives investors a metric by which to compare companies of varying sizes within the same sector, or even across different sectors.
Different Categories of Market Cap
It’s pretty common for companies to be grouped into different categories based on their market cap which allows investors to identify their size and investment potential.
So, large-cap companies normally have a market cap of at least £10 billion. These tend to be companies that are very well established with stable revenue streams and a solid, consistent track record of growth. Due to this, they’re considered low risk for investors, especially relative to smaller companies that have slower growth potential.
Next up, we have mid-cap companies. These are businesses that have market caps somewhere between £2 billion and £10 billion, striking the balance between growth potential and stability. Often, a mid-cap company is in the process of expanding and scaling its market presence, and they tend to appeal to investors who are looking for moderate risk and reward.
Last but not least, small-cap companies have market caps below £2 billion, and they tend to be younger, more niche businesses or startups of some sort. Now, they offer potential for high returns, but they also carry a lot more risk, because they’re significantly more vulnerable to market fluctuations and economic challenges.
Splitting companies into these three categories allows investors to align their strategies with their risk tolerance and financial goals.
Why Is Market Cap Important?
Market cap provides investors with a quick and easy way to assess a company’s size and market presence. It also helps people understand the company’s risk level, potential for growth and relative stability.
The other thing that makes market capitalisation useful is the role it can play in portfolio diversification. By investing in companies of varying sizes, investors can spread their risk and potentially benefit from the unique advantages that each category offers.
What Are the Limits of Market Cap?
Market cap is, undoubtedly, a super useful metric, but it still has its limitations. It doesn’t account for factors like cash reserves, debt and just overall financial health, all of which are really important.
A company with a high market cap might still face operational challenges or financial instability, while a small-cap company could be undervalued despite strong fundamentals.
Also, market cap is influenced by market sentiment and external factors, such as economic conditions or industry trends. These influences can sometimes lead to overvaluation or undervaluation of a company’s stock, making it really important for investors to consider other metrics and conduct thorough research before making investment decisions.
