Market capitalization is the dollar value of a company represented by its shares owned and traded by the public.
Companies can be public or private. If private, the shares are owned by a small number of investors who can sell those shares to others directly. If public, shares are available to purchase by anyone via the stock market.
The shares that are on the stock market are considered “outstanding,” meaning the company does not control them, nor do the individual investors who might be part of company management or board advisors.
Rather, those shares are owned by the general public, which sets the price of the shares through trading on a daily basis. Mathematically, market capitalization is the number of outstanding shares times the current share price.
By inference, the price of the outstanding shares suggests a fair price for shares not traded on the stock market. It gives an assessment of the company’s prospects and serves as a signal to management that investors believe that their decisions portend success (or failure) in the future.
Market capitalization can be misleading, however. It’s easy to conclude from news stories that say Company X is worth $10 billion that the entire company is priced at exactly that level. Similarly, it might be possible to buy control of a company for less than the value of its publicly traded shares.
Market cap is a good proxy for value for casual investors, but a closer approximation for business purposes is enterprise value, which takes into consider market capitalization and debt plus cash on hand.
Think of it this way: If you wanted to buy a fruit stand, the owner might tell you that it’s worth $1,000. He’s considering his profit from selling fresh fruit and asking you to buy the stand today for the right to enjoy that profit in the future. Let’s put the profits at $10 per day.
In effect, the fruit stand owner is saying “Give me 100 days worth of profits now and the fruit stand is yours. One hundred days from now, you can enjoy the daily profits instead.”
You might quibble with him on his estimate, but to find the true value of the business you need to know more.
Does he owe his fruit supplier $500? You are buying that debt when you buy the business. Your true cost now is $1,500. Does he have $800 in cash in the business? The price is back down to $700.
You can pay him $1,000, then pay the fruit supplier from the cash and still have $300 in the till for ongoing business costs, such as buying the next day’s fruit. Your break even is now just 70 days away, not 100.
Market capitalization is an important figure for understanding how companies compare in size. But to understand the underlying investment an investor should get a grip on all of the costs of operating the business and proceed accordingly.