Market Capitalization Explained

Market capitalization, or market cap, is the total value of a publicly traded company's outstanding shares of stock. Market capitalization is the company's current share price multiplied by the total number of outstanding shares.

For example, Company A has 10 million shares outstanding and its stock is trading at $50 per share:

Market Capitalization Company A = Outstanding Shares x Share Price

Market Capitalization Company A = 10 million shares x $50 per share = $500 million.

This means the stock market believes Company A is “worth” $500 million.

“Worth” is in quotations because this is only one way to measure of Company A’s value. If you wanted to purchase the entirety of Company A today, the stock market says it will cost you $500 million.

However, according to famed investor Benjamin Graham (1), the stock market is based on opinion in the short-term. In this view, it is only an opinion that Company A is worth $500 million. Stock prices fluctuate. If the share price drops to $49 tomorrow, the stock market suddenly values Company A at $490 million. Has Company A really lost $10 million of value in 24 hours? It’s possible, but the astute investor will do their own research to value a company.

Market capitalization also has a large role in the construction of many index funds. You may have heard of market cap-weighted indexes. Many S&P 500 indexes are market-cap weighted.

A market-cap weighted fund has a larger percentage of holdings invested in the stock of companies with larger market capitalizations. Consider the following simplified example of a fictitious five stock index:

1. Company A – Market Cap: $500 billion

2. Company B – Market Cap: $200 billion

3. Company C – Market Cap: $100 billion

4. Company D – Market Cap: $50 billion

5. Company E – Market Cap: $10 billion

Total Market Capitalization of Index= $860 billion

The weighting of each company for the index is found by:

Weight = Market Capitalization / Total Market Capitalization

1. Company A: 500 / 860 = 58.1%

2. Company B: 200 / 860 = 23.3%

3. Company C: 100 / 860 = 11.6%

4. Company D: 50 / 860 = 5.8%

5. Company E: 10 / 860 = 1.2%

These weights are very important when considering your investment in the fund. Company A is a much larger contributor to the index than Company E. To illustrate this, consider what happens to a $500 investment in the fund.

_______________________________________________________

        Company         Weight (%)         Allocation ($)*

A                  58.1                    290.50

B                  23.3                    116.50

C                  11.6                      58.00

D                   5.8                       29.00

E                    1.2                        6.00

_____________________________________________

*Allocation of Investment = Investment Contribution x Company Weight

This means the majority of the investment is used to purchase shares of Company A. This may be desirable. The astute investor would be aware of the allocation and consider whether this is reasonable.

An alternative is an equal weight index. For our simple five stock index, market capitalization is ignored and each stock would comprise one-fifth of the index.

1. Company A: 1 / 5 = 20%

2. Company B: 1 / 5 = 20%

3. Company C: 1 / 5 = 20%

4. Company D: 1 / 5 = 20%

5. Company E: 1 / 5 = 20%

In the equal-weighted index, a $500 investment would be equally distributed across the five Companies.

_______________________________________________

Company      Weight (%)       Allocation ($)*

A                  20                      100

B                  20                      100

C                  20                      100

D                  20                      100

E                   20                      100

______________________________________________

*Allocation of Investment = Investment Contribution x Company Weight

Neither method of constructing an index is inherently superior. The point is to be aware of what market capitalization means and how investment contributions are allocated when the index is market cap-weighted vs. equal-weighted.

  1. Graham, Benjamin. 2006. The Intelligent Investor: The Definitive Book on Value Investing. Revised edition (Zweig J). New York: Harper Business.

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