What is Market Capitalisation?

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What Is Market Capitalisation? Understanding How Companies Are Valued

What is Market Capitalisation?

Market capitalisation (market cap) is a financial measurement used to calculate the total value of a publicly traded company. It is determined by multiplying the company's outstanding shares of stock by the current market price per share. In essence, market capitalisation provides an estimate of the overall worth of a business on the stock market.

Market Capitalisation = Number of Outstanding Shares × Market Price Per Share

Market capitalisation is a crucial metric used by investors to evaluate company size, investment risk, and overall value. Note that this metric only refers to publicly traded companies as it includes the price per share.

The Importance of Market Capitalisation

Market capitalisation serves various purposes for investors, analysts, and other industry participants, including:

Size Indicator: Market cap serves as a quick indicator of a company's size and its significance in the stock market. It helps investors differentiate between large-cap, mid-cap, and small-cap companies.
Investment Risk: Generally, larger companies with a higher market cap are considered safer and more stable investments, while smaller market cap companies often present higher growth potential and risk.
Performance Benchmarking: Market capitalisation is an essential metric for benchmarking performance against the broader market or other investment alternatives. It helps investors assess investment performance over time and make informed investment decisions.
Diversification and Allocation: Market cap guides investors in creating a diversified portfolio and allocating assets across various market sectors and company sizes to manage risk.

Market Capitalisation Classes

Companies are generally classified into three broad categories based on their market capitalisation:

Large-Cap Companies: Firms with a market cap above $10 billion, typically considered as well-established, stable businesses with a strong presence in their sectors. These companies often offer consistent returns to investors and have lower risk profiles, making them more attractive to conservative investors.
Mid-Cap Companies: Businesses with a market cap between $2 billion and $10 billion, generally regarded as companies with growth potential. While they may not be as stable as large-cap companies, they could offer more significant returns compared to them. Mid-cap companies are suitable for investors looking for a balance between growth and stability.
Small-Cap Companies: Firms with a market cap below $2 billion, often considered as young or developing businesses with substantial growth prospects. Investing in small-cap companies involves higher risk but may also yield higher returns if the business becomes successful.

These classifications may vary across regions and often change due to inflation and market fluctuations.

Limitations of Market Capitalisation

While market capitalisation is a valuable metric for investors, it has certain limitations:

Price Fluctuations: Market prices can be volatile, affecting the market cap of a company even if underlying fundamentals remain the same. Therefore, relying only on market capitalisation may not represent a company's true value consistently.
Not Applicable To Private Companies: Market capitalisation only applies to publicly traded companies, making it an inadequate measure for evaluating the value of privately held businesses.
Subject to Market Sentiments: Market capitalisation is influenced by market sentiments that can either overvalue or undervalue a company. An inflated price due to high demand may result in inflated market cap, while an undervalued price may underestimate a company's worth.

Due to these limitations, other valuation methods should be used along with market capitalisation for a more comprehensive analysis.

Alternative Valuation Methods

Various alternative valuation methods can be used alongside market capitalisation to gain a broader perspective on a company's worth:

Enterprise Value (EV): EV takes into account a company's outstanding debt, cash, and cash equivalents while valuing the company. It represents the cost of taking over the business entirely, settling its debt, and keeping its cash reserves. EV is useful for comparing businesses with different capital structures and levels of debt.
Price-to-Earnings (P/E) Ratio: The P/E ratio is calculated by dividing a company's market price per share by its earnings per share. It is useful for comparing the relative value of companies within the same industry, as it indicates how much investors are willing to pay for each dollar of earnings generated by the company.
Price-to-Sales (P/S) Ratio: The P/S ratio is calculated by dividing a company's market capitalisation by its revenue. This valuation method enables investors to assess a company's value relative to its sales rather than earnings. It is particularly relevant for businesses that are not yet generating a profit but have a compelling revenue stream.

Market Capitalisation and Cryptocurrencies

Market capitalisation has also become a vital metric for evaluating cryptocurrencies. Just like with stocks, market capitalisation for cryptocurrencies is calculated by multiplying the outstanding coins or tokens by the current market price of the coin or token.

Crypto Market Capitalisation = Total Coins/Tokens × Market Price Per Coin/Token

Cryptocurrency market caps help investors understand the size and market value of various digital assets, thereby aiding in allocating funds in a diversified crypto portfolio.

Conclusion

Understanding market capitalisation is essential for investors to evaluate the size, value, and risk profile of publicly traded companies. While it has certain limitations, it remains a crucial tool for comparing businesses within the stock market or cryptocurrencies. Coupled with alternative valuation methods, investors can make better decisions on portfolio allocation, diversification, and risk management.

By comprehending market capitalisation and leveraging it alongside other valuation techniques, you can better understand the market landscape and make smarter and informed investment choices.