Understanding Market Capitalization: What is market capitalization, its meaning, types, and formula

Before investing in a company's stock, there are multiple factors that you must consider. The most critical of them is accessing the company's worth and potential.

This helps you understand its financial well-being, growth potential, and risk profile and make informed decisions about your investment portfolio. One of the most effective metrics to evaluate a company's value is market capitalization.

In this blog, we'll answer what is market capitalization, its types, and why it is a valuable metric for investors.

What is market capitalization Meaning?

Market capitalization or 'market cap' measures a company's value based on its outstanding shares and the market price per share. This means it can only help you evaluate publically owned companies. It is a metric that helps investors compare companies, assess their relative value, and understand their market standing.

But remember, the market cap does not indicate the company's actual worth. It represents the market's perception of the company's value based on share prices that are prone to market volatility. 

Market capitalisation formula

You can calculate a company's market cap using this simple formula:

Market Cap = N x P

where,

N is the total number of outstanding shares, and

P is the market price of one share

Let's understand this with an example.

Suppose company A has 10 lakh outstanding shares with a current market price of Rs. 50 per share. To calculate its market capitalization, we'll simply multiply these two values.

Market Capitalization = 10,00,000 shares x Rs. 50 per share

Therefore, company A has a market cap of Rs. 5 crores.

As share prices are volatile, a company's market cap can change due to market fluctuations share issues or repurchases by the company. 

A higher market cap typically represents large, well-established organizations. They have a solid track record of financial stability. On the other hand, low market cap stocks represent smaller companies with high growth potential but also come with high risk.

Types of companies based on market cap

Based on the market cap, you can divide stocks into three categories: large, mid, and small.

Let's dive into them in detail.

1. Large-cap

Large-cap stocks, meaning companies with a significant market cap of Rs. 20,000 crores or more, are typically more stable and less volatile than mid-cap or small-cap stocks. These are well-established companies with a long history of operations and a stable financial position, qualifying them as low-risk investments. This makes them favourable investment options for risk-averse investors. 

However, these companies have achieved their maximum growth potential. Therefore, while investing in them generates stable returns, they are comparatively low.

Here are some of the largest market-cap companies in India:

-Reliance Industries (Rs. 16.7 lakh crores)

-Tata Consultancy Services (Rs. 11.9 lakh crores)

-HDFC Bank (Rs. 8.9 lakh crores)

-ICICI Bank (Rs. 6.5 lakh crores)

-Hindustan Unilever Limited (Rs. 6.3 lakh crores)

2. Mid cap

Mid-cap refers to companies with a moderate market capitalization ranging between Rs. 5,000 crores and Rs. 20,000 crores. These companies typically offer the stability of large-cap companies and the growth potential of small-cap companies.

Companies with a mid-cap market capitalization are more established than small-cap companies but haven't yet reached the maturity and market influence of large-cap companies. While these stocks generate higher returns, investing in them can be slightly risky. This is because these stocks are more volatile than large-cap stocks.

Some examples of mid-cap companies in India include:

-AU Small Finance Bank (Rs. 50,000 crores)

-Abbott India Limited (Rs. 46,000 crores)

-Ashok Leyland Limited (Rs. 44,000 crores)

-Bandhan Bank (Rs. 42,000 crores)

-Alkem Laboratories Limited (Rs. 40,000 crores)

3. Small cap

Small-cap stocks, meaning companies with a market cap of less than Rs. 5000 crores, are usually in the early stages of growth. They operate in emerging industries or niche markets and have a high growth potential.

Investing in these stocks allows you to participate in the growth of these companies and earn attractive returns. This is because stocks of successful small-cap companies can potentially record a significant price appreciation over time. However, these low market cap stocks also come with higher risk and market volatility due to high competition, limited resources, and less liquidity. 

Some examples of small-cap companies in India include:

-Jyoti Resins (Rs. 1686 crores)

-EKI Energy (Rs. 1362 crores)

-Knowledge Marine (Rs. 1280 crores)

-Gujarat Themis Biosyn Limited (Rs. 1183 crores)

-Ksolves Indian Limited (Rs. 1068crores)

Why is market capitalization important?

Market capitalization is essential for investors to evaluate different stocks and make informed decisions. Here's why:

1. Understand a company's worth

Market capitalization helps you measure the value of a company and determine its worth. It reflects the market's perception of the company based on its financial performance, growth potential, and industry standing. This makes it easier to compare different companies within the same industry or sector.

2. Risk and return assessment

Many investors use market capitalization as an indicator of a stock's associated risk and potential returns. Large-cap companies are less risky and more stable but also offer lower returns. On the other hand, small-cap companies may offer high returns, but they're highly volatile and risky.

3. Universally accepted method

Market capitalization is a universally accepted metric in the financial world. It is a standardized measure to evaluate the size and value of a company regardless of the country or stock exchange. Therefore, you can make informed decisions about cross-border investments or diversifying your portfolio internationally.

Important valuation ratios to be kept in mind

Several financial ratios can be calculated based on a company's market cap. These include:

1. Price-to-Earnings (P/E) ratio: The P/E ratio measures a company's current share price against its earnings per share. It is calculated by dividing the market cap by net income of 12 months.

2. Price-to-Free-Cash-Flow (P/FCF) ratio: This ratio compares the company's market value to its free cash flow. It is calculated by dividing the market cap by 12 months' free cash flow.

3. Price-to-Book (P/B) ratio: This ratio compares a company’s market value to its book value. It is calculated by dividing the market cap by the company's total book value.

4. Enterprise Value-to-EBITDA (EV/EBITDA) ratio: This ratio measures a company’s total value compared to its earnings before interest, taxes, depreciation, and amortization. It is calculated by adding the market cap and the value of preferential shares and subtracting the total cash.

Market cap variant: Free float market cap

Free float market cap refers to the number of shares of a company that are available for trading in the public market. It does not include shares held by company executives or other parties that are not actively traded.

The free float market cap is crucial for investors as it reflects the portion of the company’s equity that can influence stock price movements.

What are the factors which impact market caps?

Several factors can impact the market capitalisation of a company. These include:

1. The demand for the products offered by the company and its ability to meet that demand. High demand can increase sales, leading to higher revenue and improved profitability, which can drive up the stock price and market cap.

2. Economic downturns or market fluctuations in a specific industry can affect a company's market cap by impacting its earnings and overall financial health. Consumers may decrease their spending, leading to lower revenues for companies.

3. Exercising warrants on a company's stocks can dilute the value of existing shares if the company does not increase its earnings.

4. The performance of a company’s competitors can also influence its market cap. If a competitor outperforms or gains significant market share, they can bring down the company's stock prices.

5. The company's reputation and reliability also impact investor confidence and stock prices. Companies with strong reputations, ethical practices, and reliable products enjoy higher stock prices.

Conclusion

Market capitalisation is an important metric to determine a company's value in the market. It provides valuable insights into a company's size, reputation, and investment potential, helping investors compare different companies and sectors to make informed investment decisions.

Frequently Asked Questions (FAQs)

1. What is the market cap of an enterprise?

The market cap of an enterprise is the total value of a company’s outstanding shares of stock.

2. How does the capital market differ from the money market?

The capital market typically deals with long-term securities, such as stocks and bonds, with maturities greater than one year. On the other hand, the money market deals with short-term borrowing and lending with maturity of less than a year.

3. What happens when the market cap increases?

When a company's market cap increases, it means its stock price or the number of outstanding shares has increased.

4. Is a high market cap good?

A high cap indicates that a company is well-established, financially stable, and less volatile. However, it's important to consider other factors to make an informed investment decision.