Investors usually struggle to grasp the complicated dynamics that determine the value of stocks. It’s common for new traders to buy stocks based on share price without considering market capitalization. The stock price is the most quoted number shown in financial news and brokers.
But the dollar price of a stock doesn’t mean much unless several other factors are taken into consideration.
A $5 stock isn’t cheap and a $100 Stock isn’t expensive
A stock that costs $100 a share could be worth less than a stock priced at $5 a share. Lower share price doesn’t always mean less expensive. For example, if a company has a market capitalization of $100 billion with 10 billion shares, its share price will be $10. Now another company has a market capitalization of $1 billion with 100 million shares, its share price is also $10. In this example, the first company with a $100 billion market cap is far more expensive, even though its share price is the same as the 2nd company.
If you own 10 shares at $100 or 200 shares at $5, you own $1,000 of a company. Owning more shares doesn’t make a difference when the amount invested is the same. If the market value of the company goes up by 10%, the return will be $100 either way. Don’t think a cheaper share price means the stock has a better chance of doubling. Some brokers allow the option to purchase fractions of a share. This will allow you to invest even if you don’t have enough saved to buy a full share.
Market capitalization or market cap is the market value of a publicly-traded company’s outstanding shares. The market cap can be easily calculated by multiplying the share price by the total number of outstanding shares.
• Stock Price: $30
• Outstanding Shares: 40 million
• Market Cap: $30 x 40,000,000 = $1.2 Billion
• Stock Price: $15
• Outstanding Shares: 200 Million
• Market Cap: $15 x 200,000,000 = $3 Billion
These examples show why
Market cap terms
• Large Cap: $10 billion or more
• Mid Cap: $1 billion to $10 billion
• Small Cap: under $1 Billion
These numbers are commonly used to separate companies in large, mid and small-cap sectors. In the 1950s a company with a market cap of $1 billion was considered a large-cap.
The terms micro-cap and mega-cap are also commonly used. When diversifying a portfolio, many investors seek to have a good mix of all three market cap sizes. This allows an investor to gain more exposure and have a more balanced portfolio.
What market cap can tell you
Market cap only reflects the equity value of the company. A company’s true market value is much more complex. There are many different metrics used to gather a company’s true value other than the market cap. A more comprehensive measure that can be used is called enterprise value (EV).
Enterprise value will also use company debt, growth potential, interest payments, taxes, and other factors. Market cap is a slightly subjective gauge of value, but not nearly as subjective as stock prices. You should look at similar companies that are within the same industry when comparing market capitalization.
A stock price is always changing and every company has a different number of shares outstanding. In this case, you cannot value a company by share price alone. This is why
Remember that a low share price doesn’t always equate to being a cheap stock. Market cap is an important metric but don’t solely rely on it for the true market value of a company.