Market Capitalization

Written By Ethan Yan

What is Market Capitalization?

Market Capitalization, or Market Cap, is the total dollar value of a company’s stock share outstanding. Shares outstanding represents the total number of a company’s stock that is held by all shareholders. This number constantly changes, as it’s based on the value of the stock per share.

The Importance of Market Cap

Market capitalization is a good measure of the company’s dollar value. Larger and more established companies are often more stable, providing secure and consistent returns, or value in their stock. Smaller companies are more volatile, but can also outpace the growth of larger companies. Although that’s the general idea of investing: High Risk, High Reward, as the growth is not guaranteed with smaller companies.

In the eyes of an investor, they see market capitalization as a measure of what kind of stocks they may want to invest in, depending on their risk tolerance. Fidelity provides a great example:

“...if you've decided on an asset allocation of 70% stocks and 30% bonds, you might spread that 70% among companies of various market capitalizations, to align with your risk tolerance” (Fidelity Learn 4).

Market Cap Segments

All company’s market cap are categorized in three different segments: Small-cap, Mid-cap, Large-cap. They are defined as such:

  1. Small-cap: Market Cap ranges from $250M - $2B. Typically younger companies are in this category, as they aim for fast growth and strong stock gains. Since they’re younger companies and are focused on growth, they are usually low on cash, which causes more volatility, meaning they are more vulnerable to downturns and failure. 

  2. Mid-cap: Market Cap ranges from $2B - $10B. Companies that fall within this range have medium risk; they’re not too vulnerable for failure, but they may also not provide exponential growth. They’re the middle ground companies.

  3. Large-cap: Market Cap ranges from $10B or more. Usually the more established companies are in this category, but they provide stability. Since they’re typically slower in growth, they often give out dividends. However, younger companies can be in this category if their fast pace growth model is successful.

There are two unofficial segments: Mega-cap and Micro-cap. Mega-cap are for companies that are $200B and more. Since they’re rare, the segment name isn’t really needed. Micro-caps are in the range of $250M or less, but since it’s not as significant in terms of investing, or they may not provide available stocks to the public, the segment title is also not needed.

Stock Splits

When a company decides to divide their stocks to multiply the amount of shares, they are performing in a stock split. What happens is that they are lowering the price of each share, but the market capitalization remains unchanged. I’ve mentioned this in my other blog: Initial Price Offering.

The reason why market cap remains unchanged is because the company will give the correct amount of shares to their shareholders, equal to the same dollar amount they had before the split. For example:

I’m an investor that owns 50 shares at Company A, valued at $4 per share. The total value I own is $200. Company A decides to perform a 2-for-1 stock split, meaning the price per share drops to $2. To ensure the market cap remains the same, they will give me another 50 shares so that my total value remains at $200.

Share Buybacks

When a company decides to purchase their own shares, they reduce the company’s shares outstanding. This action will cause an inverse reaction: As the total number of shares outstanding decreases, the earnings per share (EPS) increases. To understand why this happens let’s look at the EPS formula:

EPS = Net Income / Shares Outstanding

Since the company’s net income doesn’t change, but the shares outstanding is being reduced from the buyback, the EPS will just increase. In your head, you might think that the market cap will probably stay the same, similar to stock splits. Although the line of thinking is sort of correct, EPS isn’t the same as Market Cap. EPS measures the company’s profitability, while market cap is the total dollar value of a company’s stock share outstanding.

Does Market Cap Change During Buyback?

In theory, you would think the market cap should decrease, but the reality is often different. Let’s take a look at this scenario:

Company A has 10,000 shares outstanding, valued at $5 each, so a total value of $50,000. They buyback 1,000 shares for $5, spending $5,000 in total, which should decrease the market cap to $45,000.

This scenario clearly shows that the market cap is decreasing. The problem is that it doesn’t account for market reactions. Typically when a company is repurchasing shares, they’ll offer a fixed price, which will differ from the market price. Let’s continue the same example:

As Company A repurchases shares, investors seem to be more confident in the stock value, thereby driving the price to $6 per share. So although the total shares outstanding reduced to 9,000, the market cap increased to $54,000. The buyback created $4,000 since investors are quite confident in the company’s actions.

Although my examples are dealing with way smaller numbers, it gives a rough idea as to how market cap can actually increase rather than decrease during a buyback. The results are often more nuanced, but usually the share price increase wouldn’t be so large that the market cap will greatly increase during a buyback.

The Bottom Line

The market cap is a great tool to measure a company’s dollar value, especially when you’re deciding to invest. When they announce a stock split, it often signals more potential growth, as new investors may be able to afford the stock from the price decrease, thereby the company gains more cash for capital expenditure. This doesn’t inherently increase the market cap at all. Buybacks signal higher EPS, but the market cap often changes due to price discrepancies. However, it doesn’t automatically mean an increase in wealth, as the reality is often nuanced, and the market price of the stock may be negligible.

Ethan Yan