Stock price versus Market Cap
The market capitalization (Market Cap) of a company tells you how much the market values a company at a specific point in time. To determine the Market Cap you multiply the current price of a share in the company by the total number of outstanding shares.
Market Cap = Share price x outstanding shares
For example, if a company has a current share price of $20 and a total of 1,000,000 shares outstanding, it has a Market Cap of $20 million.
A company with a low stock price but a large number of outstanding shares can have a higher market capitalization than a company with a high stock price but low number of outstanding shares. For example, if Company A has a share price of $10 with 500,000 outstanding shares it would have a higher market cap ($5M) than a Company B with a share price of $50 and 200,000 outstanding shares ($1M).
It is important to understand that the market capitalization indicates the overall value the market has decided the company is currently worth. Based on investor perceptions of the future prospects for the company, the share price will fluctuate up and down. Market opinion can change rapidly which can have a large impact on the price of the stock which is why there are both overvalued and undervalued stocks.
One of the common misunderstandings I hear from fellow investors is “I bought a promising stock at a very low price, only $3”. You shouldn’t decide whether a stock is currently under or overvalued without also considering the number of outstanding shares. These investors implicitly feel that a $3 stock is a better buy simply because $3 a share is a better price than $15 a share. If we were referring to the price of a tomato, buying them for $3/lb would be better than paying $15/lb. However, when it comes to buying stocks, we are buying equity in a company. We are buying a fraction of a company and companies do not have the same number of outstanding shares. We are looking for the profit generating ability of the company that is available to us as a stockholders and that can be determined by the earnings per share (EPS) which considers the total number of shares outstanding.
Market cap is commonly used to classify the size of the company as follows:
Small Cap: < $1B
Medium Cap: $1B – $10B
Large Cap: > 10 B