Market Capitalization

Market Cap - Basics, Definition, How to Calculate

Market capitalization is one of the most effective ways of evaluating the value of a company. It is crucial for readers to understand that this evaluation of a company’s value is done based on a company’s stocks. Essentially, this is defined by the total market value of the outstanding shares of a company. This simple fact also means that publicly owned companies are the only ones that can be evaluated by this method of evaluation.

It is vital to understand what market capitalization is, especially for investors, since this can guide them in choosing the correct shares to invest in. Fluctuating market conditions and stock prices also impact the evaluation of a company when this method of evaluation is being used. For investors, understanding the value of a company is imperative while creating a long-term investment plan.

Understanding the value and risk associated with a company also helps an investor to make a balanced investment which is distributed across stocks from different companies. While judging companies by their market cap, it is important for investors to understand that this shows the stage of development of a company in its business venture. Investors should keep in mind this stage of development of a company while evaluating them to build their investment portfolio.

Market Capitalisation Formula

One of the major factors while evaluating a stock is on the basis of the market capitalization in India. Before going into the finer nuances, knowing the formula for this evaluation method can provide clarity to investors.

MC = N X P

Where,

MC stands for Market Capital,

N for the number of outstanding shares,

And P is the closing price of each share of the concerned company.

An example can demonstrate the calculation of market capitalization with more ease. If a company has 10,000 shares, each with a closing price of Rs.100; the total MC of the company would be computed as follows.

      MC = N X P

= 10,000 X Rs.100

= Rs.1,000,000

The total value of this company comes at Rs.10 lakh.

Importance of Market Cap

While the importance of market capitalization has been touched upon in its definition, it is crucial for potential investors to understand its need in further detail. This can also help them in understanding the market as well as its impact on the shares and value of a company.

• Universal Method

This is the most widely used method around the globe to evaluate a company. Since this is one of the universally accepted methods, this makes it easy for investors to understand a company’s value irrespective of their geographical or economic locus.

• Precise in Suggestion

Suggesting market conditions is always subject to risks since it can fluctuate due to many factors. Nevertheless, the market cap is one method which is quite precise in its evaluation. As a result, though not full-proof due to obvious reasons, it is a reliable method to judge the risk associated with investing in a company.

• Affects the Index

This method is also used to weigh the shares of different companies for the index in the share market. Using this method, stocks with higher market capitalization get better weight in the index.

• Helps in Comparison

Since this is a universal method that can be applied to evaluate any company’s market worth, it is a convenient method for investors to compare different companies. This comparison not only helps in understanding the size of a company, but also the risk associated with investing in them.

• Balanced Portfolio

Investors should maintain a balanced portfolio to ensure they do not run the risk of any major loss. This includes opting to invest in a few top companies by market cap, along with the high-risk investments in developing enterprises.

While this evaluation process is convenient and universally accepted, investors should also note that it does not consider debt and other financial liabilities of a company. Furthermore, it also does not take into account the different types of returns, like the splitting of stocks, dividends, etc.

Types of Companies Based on Market Cap

Based on this popular method of evaluating a company, there are 3 different types of stocks from which an investor can choose. Balancing out the portfolio with a good combination of all of these can minimise the chances of risk.

Companies with MC above Rs.20,000 crore are often termed as Mega-Cap Stocks. The 3 major types of stocks which investors go on to invest in are discussed in further detail underneath.

• Large-cap

These are some of the most stable groups of companies in the market. Consequently, investing in these companies is the least risky option. However, another important factor to keep in mind is that since these are stable companies, the return from these companies is comparatively low.

Typically, these companies have reached the pinnacle of their growth, and as a result, there is a lesser chance of any drastic change in stock prices. However, the low risk accompanied by less aggressive growth makes investment in these stocks a conservative option.

• Mid-cap

Companies which have had a certain growth and are somewhat stable; and yet have immense potential of growth, come under this group of evaluation by market capitalization. These stocks indicate that a company is established to a certain extent in its industry, along with the promise of further growth.

While investing in these companies can still be risky since they are not established in their industry, the risk in investing in their stocks is much less than that of the next group of companies. Subsequently, the return on them can be potentially higher than those of large-cap stocks.

• Small-cap

Constituting companies which have the least market cap are the riskiest of all stocks. These are companies who are budding and are yet to establish themselves in their industry. This makes them highly risky. Success can sky-rocket their stock prices while failure can lead to a major loss for their shareholders. These are the most aggressive investment options.

Vital Valuation Ratios to Be Kept in Mind

While learning about market cap, investors should also learn a few relevant ratios which come into play. These ratios take MC into consideration.

• Price-to-earnings ratio: This is used to estimate the future return that can be expected from buying shares of a company. The MC is divided by 12 months’ net income to calculate this ratio.

• Price-to-free-cash-flow ratio: This ratio is calculated by dividing the MC by free cash flow of 12 months. It is also used to project the expected returns.

• Price-to-book value: To calculate this, MC is divided by the total book value of the company. It is computed by deducting the total value of liabilities from the total book value of assets of an institution.

• Enterprise-value-to-EBITDA: This measures the operational returns that can be expected in the short term. EBITDA stands for Earnings before Interest, Taxes, Depreciation and Amortization. Enterprise value (EV) is calculated by adding the market capitalization with a value of preference shares, debentures and deducting total cash. The ratio is calculated by dividing the EV by EBTIDA. 

Market Cap Variant: Free-float Market Cap

The number of outstanding shares which are meant for trading by the public is called float. Free-float method of evaluating market capitalization uses this float, though it excludes the shares which are owned by company executives.

Vitally, the major difference between conventional MC and free-float method of calculation is that the former takes the total value of stocks while the latter excludes locked-in stocks. This system of indexing has been adopted in most of the major exchanges around the globe.

What Are the Factors Which Impact Market Caps?

There are quite a few factors which impact the market cap of a company. Learning these factors can aid investors in judging if a specific company is expected to offer good returns.

• Demand for the products or service of an institution and its ability to serve that demand, both are crucial factors which impact the MC of a company.
• Fluctuations in the market can impact the MC. This can be in the specific industry or an economic downturn, or both.
• Exercising warrant on the stocks of an enterprise can reduce its value.
• Performance and ingenuity of competitor brands or institutions.
• The reliability and the reputation of a company.

The number of outstanding shares of a company depends on factors like buying back of shares or issuing of new shares. In case of stock splits to issue new shares, the market capitalization of a company remains unchanged.

While understanding the impact of different factors on the MC, it is also advisable for investors to understand how investments grow or decline over the years. This is explained with the help of an example.

Considering the price of every share of a company is Rs.100 if a certain Mr. Bhagat invests Rs.10,000 he would acquire 100 shares of the company. Now when the market capitalization of this company goes up, the share prices are affected positively too. If the share prices go up to Rs. 120, the total value of Mr. Bhagats’s investment stands at Rs.12,000. Consequently, Mr. Bhagat stands to make a profit of Rs.2,000 on his initial investment of Rs.10,000.

Other Ways of Evaluating a Company’s Value (Equity Valuation and Enterprise Value)

There are a few other ways that are often used to calculate the value of an enterprise. These methods are discussed below in detail.

• Equity Value

This value is calculated by taking into account all of a company’s assets. However, this asset evaluation is done with respect to that of common shareholders (equity investors).

• Enterprise Value

The enterprise value of a company is calculated by evaluating the assets which act as the functional core of a business. Additionally, all shareholders are taken into account. This includes equities, debts, preference shares, etc.

Top 10 Indian Companies Based on Market Cap

Working in the Indian market, investors should also know the 10 largest companies by market cap in India. These are provided in the table below.