Market Cap: What it is and why it's important

An article about the meaning of "Market Cap" should be short, right?

I mean, it's basically just the value of a company.

Right?

Well... yeah. That's definitely part of the story.

But there's actually a lot more to it.

For example, have you ever asked yourself the following?

• Is Market Cap calculated using shares issued or shares outstanding?

• If Market Cap is the value of a company, what gives the company that "value"?

• Why does Market Cap matter for index investors?

I sure hadn't.

Reality check: I didn't even know these were questions to ask.

The boring part: The definition

"Market Cap" is short for "Market Capitalization".

I just point this out because some references say "Market Cap", while others say "Market Capitalization". (And someone might think they mean different things. And that someone might spend 15 minutes trying to figure out what the difference is. 🤦)

The definition [1]:

Market Cap = Current price per share × Number of shares outstanding

The not-boring part: The details

So, we need the price per share and the number of shares outstanding.

But, wait a minute...

What does "outstanding" even mean?

Here's a stack of useful definitions:

1. Shares authorized: The maximum number of shares the company is allowed to issue.

2. Shares issued: The number of shares actually created and distributed to shareholders.

3. Treasury stock: The number of shares the company holds of its own stock (from buybacks).

4. Shares outstanding: The number of shares issued, excluding any treasury stock.

   1. Note: This often shows up as "shares issued and outstanding".

5. Float: The number of shares outstanding that're free to be sold (i.e. aren't restricted stock).

So, check it out. If we look at Apple (ticker: AAPL) on Yahoo Finance, this is where see the values related to Market Cap (snapshot from July 27, 2024):

And, we can see that:

$218.04/share × 15.33B shares = $3,342B = $3.34T

The math checks out. 🙌

Where'd Yahoo get all that beautiful data?

Yahoo gets shares outstanding from a company's latest quarterly report (aka 10-Q). As of writing, Apple's latest 10-Q is their Q2 2024 report.

In that 10-Q, we can find the number of shares outstanding in the assets table. It's under shareholders' equity:

Side note: In this 10-Q, the share counts shown are in thousands. So, when it says 15,337,686 shares, it really means 15.3 billion (not million).

Side note: "15,337,686 and 15,550,061 shares issued and outstanding, respectively" means 15.3B shares were outstanding as of March 30, 2024 and 15.5B shares were outstanding as of September 30, 2023. I just point this out because someone might think it means 15.3M shares were issued and 15.5M were outstanding. And that someone might spend an hour trying to figure out how that's possible since shares can't be outstanding unless they're issued. 🤦 x 2

Then, the share price comes from the most recent sale/purchase of Apple stock.

Wait... that means a company's Market Cap is constantly changing

That's right.

Each purchase/sale of shares changes a company's Market Cap.

So does anything that changes the number of shares outstanding.

For example:

• Share buybacks: Reduces outstanding share count

• Conversion of convertible debt to shares: Increases outstanding share count

• Exercise of warrants: Increases outstanding share count

• Selling new shares to raise funds: Increases outstanding share count

• Stock-based compensation for employees: Increases outstanding share count

It doesn't seem like a change in the number of shares outstanding makes a company worth any more or less.

But, Market Cap equals: current price per share × outstanding share count. So, the change in share count does change the Market Cap.

Over time, the price per share will adjust as buyers and sellers of the stock bring the company's Market Cap back to their perceived value of the company.

I'm not really sure how quickly this process typically happens.

Either way, I know I've never considered share count changes when deciding what to pay for a stock. Instead, I've decided what to pay based on dopey things like yesterday's share price. 🙄

Room to improve! 💪

So, now we understand Market Cap. What's it useful for?

A company's Market Cap gives us some clues about:

• The potential to be acquired

• The potential for funds to invest in the company

• Volatility

• Liquidity

This is why companies are often categorized by Market Cap.

It makes it quicker to identify companies that might meet our investment requirements.

The common Market Cap categories are [1, 2]:

• Mega cap: $200B and up

• Large cap: $10B to $200B

• Mid cap: $2B to $10B

• Small cap: $250M to $2B

• Micro cap: $50M to $250M

• Nano cap: less than $50M

Note: Nano cap isn't as widely recognized as the other categories, so you might sometimes see micro cap defined as "less than $250M".

Buyer beware!

Here's where Market Cap has a serious impact on your investment.

The SEC has fewer reporting requirements for companies with less than $250M of public float [3]. (Note that that's float rather than total shares outstanding.)

This includes:

• A less detailed business description

• No stock performance graph

• No disclosures of risk

• No detail on executive compensation

• Only 2 years of audited financial statements rather than 3

• Etc.

If you're going to invest in micro caps and nano caps, it's really important to read the following guide from the SEC:

Microcap Stock: A Guide for Investors

I see you, index fund investor 👀

Do you invest in index funds?

Smart choice! Warren Buffet approves. 👍

In that case, Market Cap is pretty important for you.

Why?

Because Market Cap is a key criteria for inclusion in indices like the S&P 500.

To be included in the S&P 500, a stock's Market Cap must be at least $18B (as of writing) [4].

Additionally, index funds tend to be weighted by Market Cap. That is, the bigger the stock's Market Cap, the more shares the fund holds.

So, if you own a standard S&P 500 index fund, you're really mostly holding Apple, Microsoft, and Nvidia (as of 2024-07-27):

Making sense of headlines

With what we know about Market Cap, we can also respond appropriately to headlines.

For example: "Tech selloff erases $1.1 trillion of 'Magnificent Seven' market cap in five days".

We know that this change in Market Cap is most likely related to a decline in share prices (versus an increase in share count).

So, the headline's saying that the share prices of 7 specific stocks (AMZN, AAPL, GOOG, META, MSFT, NVDA, TSLA) declined such that the market value of all their shares combined declined by $1.1T.

At the time of the article, the sum of those companies' Market Caps was about $15T. So, the companies lost about 6.8% of their market value in a week:

$1.1T / ($15T + $1.1T) ~= 6.8%

That's a decent amount of movement for mega caps.

But, even after the decline, the companies are up something like 25% since the previous year. The decline's not really that big of deal.

This is just a sensationalist headline trying to get attention with a big number. 👎

Best to ignore.

Realization: Market Cap is subjective

Wait a sec...

Since Market Cap is based on the price rando buyers are willing to pay for a share at some moment in time, that means Market Cap's a subjective valuation.

It's a value of the company.

But, it's not the value of the company.

That's why it's possible to find 10x investments

A company's Market Cap may be higher or lower than what the company's actually worth.

Meaning we can sometimes buy stock for less than what it's worth.

We should never trust the price others are offering us for their shares.

Instead, we need to make a better judgement of their value.

And, ultimately, only buy when price aligns with our objectives.

References

1. Market Cap Explained. FINRA. Retrieved 2024-07-27.

2. Lucas Downey. Nano Cap: What it Means, Risks and Rewards. Investopedia. Retrieved 2024-07-27.

3. Amendments to the Smaller Reporting Company Definition. SEC. Retrieved 2024-07-27.

4. S&P U.S. Indices Methodology. S&P Global. Retrieved 2024-07-27.

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