What it means
If a company has 100 million shares and each trades at $50, the market is valuing the company's equity at $5 billion. That is its market cap.
The figure changes every time the share price moves, so it reflects the collective judgement of investors about the company's prospects at that moment rather than any accounting measure. A company's market cap can be far above or below the book value of its equity, and the ratio between the two (price to book) is itself a valuation signal.
Market cap is the standard way to describe company size for investment purposes. Categories vary by market, but in the United States large-cap generally means above $10 billion, mid-cap between $2 billion and $10 billion, small-cap below $2 billion, with micro-cap and mega-cap at the extremes.
Index providers use market cap to decide which companies enter an index and, in most indices, how much weight each carries. Funds that track those indices then buy in proportion, which is why a rising market cap can attract further buying.
The measure has limits. It values only the equity.
A company with a $5 billion market cap and $3 billion of net debt costs a buyer $8 billion to acquire outright, because the buyer takes on the debt; that $8 billion is the enterprise value, and it is enterprise value, not market cap, that should be compared with operating measures such as EBITDA. Market cap also says nothing about liquidity: a company with a large market cap but most shares held by a founder may have very few shares actually available to trade, which is why indices often use a free-float adjusted market cap.
For managers, market cap is what shareholders own and what an acquirer would have to pay. For investors, it is the price of the whole company, to be set against what the company earns, owns and is likely to become.
In practice
Real-world examples.
Example
A technology company with 3 billion shares at $200 each has a market cap of $600 billion and sits among the largest constituents of major indices.
Example
A biotech company with a $400 million market cap is classified as small-cap and is held mainly by specialist funds rather than index trackers.
Example
Two companies with the same $2 billion market cap have enterprise values of $2.2 billion and $4.5 billion because the second carries far more debt; the second is the more expensive business.
Think of it
“Market cap is like the price tag on a company. It's what all the shares would cost if you bought the entire ownership stake at today's prices.
Formula
Calculation
Market Capitalization = Share Price x Number of Shares Outstanding
Enterprise Value = Market Capitalization + Total Debt minus Cash and Cash Equivalents
Free-Float Market Cap = Share Price x Shares available for public trading
Worked example. A listed retailer has 240 million shares outstanding and its shares close at $18.50.
- Market cap = 240,000,000 x $18.50 = $4,440,000,000
The retailer has $1,200,000,000 of borrowings and $350,000,000 of cash.
- Enterprise value = $4,440,000,000 + $1,200,000,000 minus $350,000,000 = $5,290,000,000
If EBITDA is $620,000,000, the EV/EBITDA multiple is $5,290,000,000 / $620,000,000 = 8.5 times. Using market cap instead of enterprise value would give 7.2 times, understating what a buyer would really pay for each dollar of EBITDA.
The founder holds 35% of the shares and never trades them. Free-float market cap = 65% x $4,440,000,000 = $2,886,000,000, which is the figure an index provider would use to weight the company.
If the share price rises to $22 on good results, market cap becomes $5,280,000,000, an increase of $840 million in the equity's value with no change in the number of shares or in the company's debt.Case study
Seen in the real world.
An investor compared two hotel groups. Group A had a market cap of $3 billion and EBITDA of $500 million; Group B had a market cap of $2 billion and EBITDA of $450 million. On market cap to EBITDA, A traded at 6.0 times and B at 4.4 times, so B looked much cheaper.
The investor's analyst insisted on adjusting for debt. Group A had net cash of $200 million, giving an enterprise value of $2.8 billion and an EV/EBITDA multiple of 5.6. Group B had net debt of $2.5 billion, giving an enterprise value of $4.5 billion and a multiple of 10.0.
B was not cheap; its shareholders owned a thin slice of a heavily indebted business, and its low market cap reflected the risk that the debt would consume the equity if trading weakened. The investor bought A. Eighteen months later B raised emergency equity at a 40% discount to repay lenders.
Watch out
Common mistakes.
- Comparing market cap with operating profit or EBITDA. Those belong to the whole business, including lenders; use enterprise value.
- Reading a high market cap as a sign of a large business. It is a sign of a highly valued one; a company with modest revenue can carry a huge market cap if investors expect rapid growth.
- Treating market cap as the price at which the whole company could be bought. Acquirers usually pay a premium, and must also refinance the debt.
Questions
People also ask.
What is the difference between market cap and enterprise value?
Market cap values the equity. Enterprise value adds net debt to value the whole business.
Does market cap change when a company issues shares?
Yes, mechanically: more shares at the same price raise it. Whether the share price holds depends on what the company does with the money.
Why do index funds use free-float market cap?
To weight companies by the shares actually available to buy, avoiding forced buying of shares that founders or governments will never sell.
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