Getting started on your road to financial freedom, you may see the concept of market capitalization (market cap) floating around various place.
This post will be a simple explanation of the concept, just so you can scratch it off your “to read/to know” list and go back to doing the work and learning more about passive income, investing, or side hustles.
The market value of a company refers to how much its stock is worth. The value can change within minutes because of influences such as stock volatility. To obtain information on market cap values for your favorite stocks, you need to DYOR (do your own research).
Why is Market Capitalization?
+1 if you get the Avengers: Infinity War reference.
Market capitalization is important because companies with higher market cap values tend to have greater revenue-generating potential. That's why they're used in some investment choices.
This may also be important to you if you want to start living off of your monthly, quarterly, or annual dividends.
One way market caps affect investment decisions is through the price-to-earnings ratio.
The higher the ratio, the more the stock is valued. When a stock's market cap comes up against its earnings per share, the ratio helps investors understand the potential earnings for their share.
This is also known as dividend yield.
Companies are typically divided according to market capitalization: large-cap ($10 billion or more), mid-cap ($2 billion to $10 billion), and small-cap ($300 million to $2 billion).
How is Market Cap First Calculated?
Now that we know that market cap refers to shares of a company, how is it calculated for companies that don't have any shares issued yet?
Market cap is first calculated when a company goes public. This is also known as an IPO (Initial Public Offering).
What happens during an IPO? An IPO is an initial public offer of stock. A company sells shares of stock and, in return, receives funds from investors. The IPO helps the company issue more shares and, therefore, increase their market cap.
How is an IPO priced?
But how do these companies that go public get their 1st stock price (ie. the stock price on Day 1 of being public)?
The stock price is partially calculated by determining the total income that a company has earned over a specific period of time, usually a year. The more money that a company makes, the higher their stock price will be.
Other deciding factors of that IPO stock price are:
- what is the demand for the product or service?
- how has this company been growing privately?
- how does this company foresee their growth once going public?
- what industry is it in?
The Market Decides
But, actually, whatever that IPO price may be, eventually the market (institutional and retail investors) decide how much it's worth.
For example, Snap went public in 2017 at $17 per share and, after the initial hype, it started trading below their ‘IPO price' for a good amount of years (even falling below $5 per share at some points) only to recover strongly a few months into the pandemic.
How Does Market Cap Affect a Company?
A large-cap company (your Amazons, your Facebooks, …) are much more desirable to institutional and retail investors, which, in turn, leads to higher prices for the stock.
Whereas mid- or low-cap companies are less attractive to those same investors, which is reflected in lower prices for the stock.
Some volatility is normal and to be expected on a daily basis in a company's market cap.
However, very big changes (like Facebook in Q1 of 2022) can shave off a lot of a company's worth, which gets the financial journalists writing articles about it, leading to more investors selling their stock, leading to more decreases in that company's value.
A company's market cap is also a factor of how attractive it is to potential buyers of the company, should they want to sell.
So, what is market capitalization?
Okay, I know, I know, that was a lot of theory stuff. But, you wanted to know!
Now, simply, in a few paragraphs: what is market capitalization?
Market capitalization, or market cap, is the total outstanding value of a company's outstanding stock shares. Since companies are often listed on the New York Stock Exchange, the market cap of these companies is determined based on the price of their shares.
For example, if Snap has 1000 shares outstanding of $1000 each, their current market cap is $1,000,000 (1000 x 1000).
This also means that, if their share price goes up, their market cap increases. If Snap share price were to go up with 10%, their market cap would now be $1,100,000 (1000 outstanding shares x $1100 share price).
If you prefer a video explainer on market cap, you can watch one here: Richard Hopkins' does a really good explanation of them.
Should you even care about market cap?
Ah, the actual question, now that your curiosity has been stilled a bit. Should you even care about all, or any of this stuff?
If you're a day-trader in stocks or crypto, then yes, you probably should.
If you're one of those people who just can't not live that kind of life, the more power to you, and I hope this information was helpful for you.
But, assuming you're the 99.4% who isn't lusting after a life like that, this information really doesn't matter to you.
Remember that the road to financial freedom is simple (fyi: simple ≠ easy!).
Spend less. Make more. Invest the difference.
You already know that, as someone pursuing early retirement, you're better off investing in ETFs vs stocks
The ETFs, whether you're going with a Three-Fund Portfolio, a Simple Path to Wealth route, or the advice that my buddy Josh recommends, it'll be, at most, a handful of ETFs you'll be holding for multiple years. Maybe even decades.
The issuers of those exchange-traded funds do this market cap think work for you. It's not on your plate, and you shouldn't scoop it on there either.
Remember to live your life outside of the spreadsheet, as Ramit Sethi has said.
If you invest in ETFs, you want to consider long-term timeframes, so you don't need to worry about your retirement nest egg on a day by day basis. The effect this we'll have is that you're free to focus on other things, including your family, your work, or (gasp!) hobbies.
What do you think? Do I have a point?
Disclaimer: I am in no way a certified expert. I have no formal financial education. I am not a financial advisor, portfolio manager, or accountant. This is not financial advice, investing advice, or tax advice. The information on this website is for informational and recreational purposes only.
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