July 15, 2020
You sit down and decided you wanted to add your first stock to your portfolio, you entered the stock ticker of your favorite company, but before you buy you see a bunch of terms next to the chart of the stock price (which you hope moves toward the upper right throughout your time as a new shareholder), but you notice something: there are a bunch of terms you don’t understand.
Welcome to the first installation of Explain That Metric! Consistent with our theme here of making the investing world more transparent, in this series we aim to break down the common ways that investors compare companies and put them into terms we can all understand.
What’s more important than the price of a stock? How do I find the value of an entire company? What is a standard number that I can use to compare wildly different companies objectively? Our metric today is called market cap and despite its importance many investors altogether ignore it and fixate more on the price of a stock.
What is market cap?
The market cap (short for market capitalization) is the value investors are giving to the entire company. This sounds like it is a lot more difficult than it really is, but it is really easy to calculate. All you need to do is take all of the shares outstanding and multiply them by the current stock price. Since the stock price is what investors are willing to value one share of the company, and the outstanding shares are all the shares available, the market cap reflects what investors value the company at as a whole.
Example: If my company has 1 million shares outstanding, and a current stock price of $10, we have a market cap of $10 million.
You may see this and think
“Well the market cap then probably is ignored because the stock price accounts for enough to be the main focus, plus after all it is what you, the investor pay.”
While it makes sense to focus on the stock price, it also really doesn’t.
A common myth in investing is that stock price means value, and this is simply not the case. Let’s look at market cap again:
Say my company with the $10 million market cap at $10 a share was compared to a company with $100 shares, but with only 10,000 outstanding shares. Despite my company having a lower share price it’s worth significantly more at $10 million compared to the second company which clocks in at $1 million.
See how the market cap may be a better indicator then for the value of the company?
The great thing about a market cap is you can then see how investors value any publicly traded company. It allows you to see that investors have given Visa a large market cap than say Mastercard, or you can compare Mastercard to Starbuck in size, and so on. This is the beauty of the market cap, it allows for a direct comparison between companies within the same sector, yes, but also in unrelated markets.
The thing about a market cap that isn’t normally used when looking at analyst reports is how it can be used to measure potential. Now that sounds confusing but hear me out: if you have a company with a $1 billion market cap, it is in some ways easier for your investment to increase by a factor of 2, 3, or even 10 than it would be for the same company with a $100 billion market cap. Now this is by no means a recommendation to go out there buying super small companies, in fact most small companies are small for a reason. What this means is that the market cap can serve as a wonderful tool when you’re deciding between opportunities for growth within two companies you admire.
** Disclaimer: The Tempered Bull is committed to enhancing the finance wellbeing of our readers; however, these articles should not be your only resource. The suggestions made here are meant to be taken in conjunction with professional financial assistance. We are not financial professionals, just regular people with a passion for sharing our experience. The Tempered Bull does not have any private knowledge about the companies we discuss, and The Tempered Bull and its associates do not benefit from your purchase or sale of any equites. The Tempered Bull has a disclosure policy.