Market capitalisation is used by investors to classify companies as large, mid or small-cap. The terms micro and nano-cap are also sometimes applied. These categories are frequently used as investment criteria, particularly when trying to maintain diversification in a portfolio of assets. As with most investor ratios, market cap is often used in conjunction with other measures – such as book value – to help analyse a company’s overall value to the shareholder.
How is it calculated?
The following formula is used to calculate market capitalisation:
\(Market\: capitalisation \:=\: price\: per\: share\:\times\:number \:of\: shares \:outstanding\: or\: issued\)
The price per share of a company and the number of outstanding shares can usually be found either from newspapers or the internet. The audited accounts will always give the outstanding or issued share capital. A company’s market cap should always be quoted in the currency unit in which the shares are priced.
Example
Company ABC’s shares are quoted at ¥12.46 each. The company has 3,500,000 shares outstanding. Using the above formula, the company’s market capitalisation is ¥12,110,000 ¥ 3.46 x 3,500,000, which according to the classifications below would make it a small-cap company.
Classifications
The classifications for market capitalisation are not precise or fixed and may vary between different exchanges. The classification of shares into large, mid and small-cap is made on the basis of the relative size of that particular stock exchange. For example, a mid-cap stock in the US would be classified as a large-cap company in India. The classifications also vary over time – so what was classified as large-cap in 1960 is almost certainly going to be different in 2013.
Free-float market capitalisation
The above method for calculating market capitalisation is referred to as the full market capitalisation. In reality however, not all of the outstanding shares are freely available to be traded – they may be ‘locked’ in a government or strategic holding for example. This information can usually be obtained from the company itself or the exchange. There may also be more than one class of share.
Free-float market capitalisation is calculated by multiplying the full market cap by what is known as the free-float factor. This is determined by dividing the number of shares readily available for trading in the market by the total number of shares outstanding and rounding it up or down to the nearest 0.05 increment.
If we continue with the example of company ABC and if, out of the 3,500,000 shares outstanding, 2,875,000 are readily available to trade, the company’s free-float factor can be calculated as follows:
\(\frac{2,875,000}{3,500,000} = 0.821 \) , which is then rounded down to 0.80.
\(This\: means\: that\: the\: company’s\: free-float\: market\: capitalisation \:is\: $\: 2,110,000 \:\times\: 0.8\: = \:$ \:9,688,000\)
Considerations
Market capitalisation is not the only measure to evaluate a company’s financial value. A common weakness in this calculation is that it takes into account the sum total of equity. Debt holders have a claim on the company and this should be taken into consideration. Market capitalisation calculation is hence often used together with other formulas, such as enterprise value and valuation ratios. Market capitalisation can also be useful for valuation and any valuation ratio using share prices can also be restated in terms of market capitalisation.
Other uses
The market capitalisation formula is not used exclusively for calculating the market value of a company’s shares – it can also be used to determine the market value of an industry, a stock exchange or even an entire country.
