Wednesday, November 30

Market Capitalization Meaning: Why Price Doesn’t Always Equal Value


Market capitalization, also commonly referred to as “market cap,” is a common term thrown around by investors that many people think to be complex, but it’s extremely important.

In reality, it’s a simple metric that investors use to evaluate publicly traded companies, and, in my opinion, it gets way too much attention.

That said, you should know what a company’s market cap is…but you shouldn’t base your investment decision on it alone.

Here, we’ll define what market capitalization is, why it’s important, how to calculate it, and, most importantly, how and when to use it as part of your investment strategy. We’ll also touch on the various market caps a company can have—large-cap, mid-cap, small-cap, and more.

What is Market Capitalization?

Simply put, market capitalization is how much a company is worth according to what the stock market has priced it at.

Market capitalization reflects the total value of a company’s outstanding shares. The more outstanding shares and the higher the price of those shares, the greater a company’s market cap will be.

To put it another way, it’s the amount of money it would require to buy the company outright in a single transaction.

Market Capitalization is NOT…

Market capitalization is often thought of as what the company is really worth — the value of the business.

You’ll often hear analysts say this, but it isn’t true.
Even professors at some of the best universities in the country have made this mistake over and over again. They assume the market price is what the business is worth.

As Warren Buffett says, “Nothing is further from the truth.”

A company’s market cap is based on the price of its shares, and, as Rulers know, price does not always equal value.

Just think of meme stocks like GameStop and Dogecoin. These companies have been subject to volatile stock price swings that have nothing to do with their inherent value, but rather their popularity on social media.

It’s critical to understand that the price of a stock does not necessarily reflect the value of a company. In this way, the market cap only gives you a piece of the story.

Market capitalization is about the price of a company; that’s it.

Why is Market Cap Important?

So, if market cap is only a measure of price, not value, why do we care about it?

A company’s market cap reflects its size, which can help investors better understand how big a company is and how much potential it has to grow.

Market caps can range from millions to trillions, but investors typically use three main market cap categories: small-cap companies, mid-cap companies, and large-cap companies.

While these categories can be helpful for the average investor, they’re more widely used by investment funds trying to create a diversified portfolio for their clients with a mix of smaller and larger companies.

Large-Cap Stocks

Any company with a market capitalization of more than $10 billion is considered a large-cap company.

Large-cap companies tend to be fairly stable. They are well-established, have a long-standing track record of past performance, and have earned a large share of the market, but that doesn’t mean they’re without risk.

The con of large-cap stocks is that their growth is often much slower because they’ve already taken hold of a majority of the market.

An example of a large-cap company is Walmart. Their market cap is around $370 billion.

Mid-Cap Stocks

Mid-cap companies have a market cap between $2 billion and $10 billion. These companies may serve niche markets or have a lot of competition that has kept them from growing to the size of a large-cap company.

Or, they may be newer companies still in a high-growth phase. Some examples of mid-cap stocks include Robinhood, Hyatt Hotels, and Docusign.

Small-Cap Stocks

Small-cap companies are smaller companies with a market cap of somewhere between $300 million and $2 billion. Companies with a smaller market cap than $300 million are considered micro-cap.

Unlike the established companies that make up large-cap stocks, small-cap companies have a higher potential for risk, but also an aggressive growth potential that could result in dramatic returns.

Small-cap stocks include Coursera, SmileDirectClub, and Health Catalyst.

How To Calculate Market Capitalization

Anyone can calculate market capitalization with basic multiplication.

It’s a simple, straightforward calculation you can perform in a few seconds to determine the market caps of companies you want to invest in.

Market Cap Equation

Market capitalization is determined by taking the number of a company’s shares and multiplying that by the current price of one share.

The market cap formula is simply this:

The per share price of a company (x) the total number of outstanding shares of that company (=) Market Capitalization

As an example, a company that currently has 10 million shares that are selling for $50 per share would have a market capitalization of 500 million dollars.

You can also use my market capitalization calculator to keep things easy. Just plug in the number of outstanding shares and the price per share, and it will spit out the market cap for you.

Market Cap vs. Market Value

Market capitalization, or market cap, is not the same as market value (even if someone uses the terms interchangeably).

To determine a company’s true value, many metrics are used rather than only the company’s stock price and outstanding shares.

Not only are market capitalization and market value calculated differently, but they also affect our potential returns very differently. Here’s what you need to know.

They’re Calculated Very Differently

While market cap and market value are each a measurement of corporate assets, they each take incredibly different roads to get to what is essentially the same destination.

Market cap is a very straightforward calculation, but market value is infinitely more complex. It’s assessed using factors like price-to-earnings, return-on-equity, and others.

Other metrics that are usually considered when calculating market value include outstanding bonds, corporate debt, interest payments, and even long-term growth potential.

Market cap also tends to fluctuate over time, particularly during a business or economic downturn, such as a recession.

What We Pay vs. What It’s Worth

The key difference between market cap and market value is that one represents price, and the other represents value — and when it comes to a company’s share price, the two are rarely equal.

Price is what you pay for, but VALUE is what you get.

When you understand that about market capitalization and market value, you’ve just taken your first major step to becoming a really great investor.

Let’s say you go out and buy a new Maserati. We’ll say that the value of the car is $100,000. If I paid $200,000 for the car, it doesn’t mean it’s worth $200,000. That’s just what I paid for the car. I massively overpaid for it.

On the other hand, if I paid $50,000 for it, it also doesn’t mean it’s worth $50,000. That’s just what I paid.

When it comes to stock investing in the public market, it’s really important to understand that the market cap is just what we pay.

What we need to know is what the company is worth.

What is the company’s value?

This is what Rule #1 investors care about.

How To Use Market Cap

Market capitalization can play a useful role in your investment strategy. It just shouldn’t be the foundation of your strategy.

You can use it to determine the size and, thus, the general potential of a company’s enterprise.

You can also use it to compare the company’s true value with what the market has priced it at and this will tell you if the company is overpriced or on sale.

Find the Size of a Company

You can calculate market cap to determine the size of a company you’re interested in investing in. Is it a large-cap, mid-cap, or small-cap stock?

This will give you a general overview of the growth potential and stability of a business. Many people also use a company’s market capitalization to develop a balanced stock portfolio, i.e., a mix of small and large companies to reduce investment risk.

For Rule #1 investors, though, the size of the company is less important than the quality of the company. Large caps, mid caps, and small caps can all be wonderful investments if they meet the right criteria.

Find the True Value of the Company

If we make market cap the only metric to determine whether or not to invest, we’re letting the stock price of the business tell us what the business is worth, instead of using all of the data available to a Rule #1 investor.

In order to find the true value of the company, it’s critical to look beyond just the market cap. You need to analyze the company from head to toe, including its management, competition, profits, how it allocates its cash, etc.

Here are important financial metrics to evaluate the financial health of a company. These financial metrics are key to determining whether or not a company is worth your investment and will make you money down the line.

Don’t Be Fooled

Don’t be fooled into thinking that the market cap represents what a company is actually worth. A big mistake that people and investors make is assuming that whatever the market is charging for a company, is what it’s worth.

But many companies are highly over-valued! And investing in them at that time could spell disaster for your returns.

Let me reiterate this: just because you pay a price for something, doesn’t mean that’s what it’s worth.

In volatile markets, that price could drastically change from one day to the next even if the value of the company didn’t.

Focus on determining the company’s true value and let the market cap measures simply be a benchmark you look at to learn whether the market is over or under-valuing the company.

How To Determine A Good Investment

If market cap isn’t how you determine a good investment opportunity, what is?

To properly value a company, you need to use the 4 Ms and all the financial data available.

Does It Pass the 4 Ms?

The 4 Ms are four components of a company that help tell the whole story. This includes Meaning, Moat, Management, and Margin of Safety.

These are factors you can evaluate before you even look at the financials of a company!

Ask yourself:

Does it have meaning to you?

Meaning, do you understand how the business works?

Does the business have a competitive advantage that sets it apart?

Is the management trustworthy?

You can learn more about how to use the 4 Ms to evaluate a business right here.

Is It On Sale?

If you look at the market capitalization and see that it’s way below what you have calculated the true value of the company to be, then you know that it is massively on sale.

In other words, if we see that the company is worth more than the current stock price, then we know that we’re essentially buying a $10 bill, for $5 bucks.

This is great news!

It means that you can invest in the company today and know that the open market will eventually realize how much the company is worth and that the share price will rise, giving you an incredible return on your investment.

Will it Grow?

For long-term investors, like us, a critical question to ask is…

How big is the company, and does it have room to grow?

Just because a company has great past performance doesn’t necessarily mean it will succeed in the future.

You have to look at if the management is making decisions that are in the investors’ best interest. And will it face more competition as it gets bigger that it can’t surpass?

Asking these questions will help you determine what’s ahead.

Even if a company is in a great position today, it needs to have a promising future potential to double or even triple your money.

So, how do you know if a company is a good buy or not? Don’t rely just on the market cap…

Remember that the market cap is a reflection of what we would pay today to own a piece of the company. But this price is not the true value of the business.

Rely on the right metrics first to determine whether a company is a worthy investment. Then, you can use the market cap to help you determine if it’s on sale and if it has the growth potential you’re looking for.

If you’ve been using market cap more than you should, or you’ve never heard the term before, take my Investing IQ quiz. It will measure your investing knowledge and show how you could switch up your strategy and increase your returns.

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Market Capitalization Meaning: Why Price Doesn't Always Equal Value

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Market Capitalization Meaning: Why Price Doesn’t Always Equal Value

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The market capitalization price of a company and the company’s actual value are two VERY different things. Learn how to properly value companies here.

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Phil Town

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Rule One Investing

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