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Market Capitalization

Guide to Understanding Market Capitalization ("Market Cap")

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Market Capitalization

How to Calculate Market Capitalization (“Market Cap”)

Market capitalization, or “market cap” for short, is defined as the total value of a company’s equity and is typically used when discussing the valuation of public companies.

Otherwise, if the company is private – i.e. if its shares of ownership are not publicly traded on the stock markets – the value of its equity should be referred to as equity value, instead.

When equity analysts and investors discuss the value of companies, two of the most frequently used terms are “equity value” and “enterprise value”, which are briefly explained below:

  • Equity Value (Market Capitalization): The value of the company to the owners of its common equity (i.e. the common shareholders)
  • Enterprise Value: The value of the operations of the company to all stakeholders – or, said differently, the value of a company’s operating assets minus its operating liabilities

Market Cap vs. Enterprise Value Graph

Enterprise Value vs. Equity Value Illustration

Market Cap Formula

To calculate the market capitalization of a company, you must multiply the company’s latest closing share price by its total number of diluted shares outstanding, as shown below:

Formula
  • Market Capitalization = Latest Closing Share Price × Total Diluted Shares Outstanding

Note that the common share count used in the calculation should be on a fully diluted basis, which means the potential net dilution of options, warrants, and other mezzanine financing instruments like convertible debt and preferred equity securities should be incorporated.

If not, there is the risk that the market capitalization calculated is lower than it actually is, as there would be share issuances left unaccounted for.

Equity Value vs. Enterprise Value (TEV)

Enterprise value (TEV) is the value of the operations of a company to all capital providers with claims, such as common shareholders, preferred shareholders, and lenders of debt.

On the other hand, equity value represents the residual value left to only equity holders.

While enterprise value is considered to be capital structure neutral and unaffected by financing decisions, equity value is directly affected by financing decisions. Therefore, enterprise value is independent of the capital structure, unlike equity value.

Calculating Market Cap from Enterprise Value

Under an alternative approach, we can calculate the market cap by subtracting net debt from the enterprise value of the company.

For privately held companies, this particular approach is the only viable method to compute the equity value, as these companies do not have a readily available public share price.

To get from the enterprise value of a company to its equity value, you must first subtract net debt, which can be calculated in two steps:

  • Total Debt: Gross debt and interest-bearing claims (e.g. preferred stock, non-controlling interests)
  • (–) Cash & Cash Equivalents: Cash and cash-like, non-operating assets (e.g. marketable securities, short-term investments)
Formula
  • Market Capitalization = Enterprise Value – Net Debt

In effect, the formula is isolating the value of the company belonging solely to common equity shareholders, which should exclude debt lenders, as well as preferred equity holders.

Under the treasury stock method (TSM), the common share count factors in the exercise of potentially dilutive securities, resulting in a higher number of total common shares.

While the treatment of these securities can be specific to the firm or individual, if an option tranche is “in-the-money” (i.e. there is an economic incentive to execute the options), the option or related security is assumed to be executed.

However, in recent years, the industry norm has shifted towards more conservatism by taking into account all potentially dilutive securities issued, no matter if they are currently in or out of the money.

The proceeds received by the issuer as a result of the exercise are then assumed to be used to repurchase shares at the current share price, which is done to minimize the net dilutive impact.

Zoom vs. Airlines COVID Example

Expanding further on the concept of equity value vs enterprise value, many retail investors in early 2020 were astonished that Zoom (ZM), the video conferencing platform that clearly benefited from COVID tailwinds, held a higher market cap than seven of the largest airlines combined at one point.

One explanation is that the market caps of the airline companies were temporarily compressed due to the travel restrictions and uncertainty surrounding the global lockdowns. In addition, the U.S. government bailout had not yet been announced for investor sentiment to stabilize around airline companies.

Another consideration is that airlines are significantly more mature and thus hold significantly more debt on their balance sheets. The airline industry is well-known for its monopoly-like nature in which only a handful of companies have a firm grasp of the market, with minimal threats from smaller players or new entrants.

The reason these airline industry dynamics are relevant to the topic of market capitalization is that companies in low growth but stable and mature industries are going to have more non-equity stakeholders in their capital structures. In effect, the increase in debt leads to lower equity values, but not always lower enterprise values.

Zoom Airlines Performance

Market Capitalization of Zoom vs Top 7 Airlines (Source: Visual Capitalist)

Market Capitalization Calculator – Excel Model Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

Submitting ...

Step 1: Financial Assumptions

In this exercise, we have three different companies for which we’ll calculate the equity value as well as the enterprise value.

Each company has the following financial profiles:

Company A Financials

  • Latest Closing Share Price = $20.00
  • Diluted Shares Outstanding = 200mm

Company B Financials

  • Latest Closing Share Price = $40.00
  • Diluted Shares Outstanding = 100mm

Company C Financials

  • Latest Closing Share Price = $50.00
  • Diluted Shares Outstanding = 80mm

Step 2: Market Cap Calculation

The market capitalization for all three companies can be calculated by multiplying the share price by the total diluted shares outstanding.

For instance, in the case of Company A, the formula for calculating the market cap is as follows:

  • Market Capitalization, Company A = $20.00 × 200mm = $4bn

Note that although it is not explicitly broken out here, the weighted average of the diluted share count should be used when calculating the market cap of companies.

Upon performing the same process for all three companies, we get $4bn as the market cap for all three companies, despite the different share prices and diluted shares outstanding assumptions.

Step 3: Equity Value to Enterprise Value Bridge

In the next part of our tutorial, we’ll calculate the enterprise value starting from the market cap.

The simplest calculation of enterprise value is equity value plus net debt.

Regarding the net debt figures, use the following assumptions:

Net Debt

  • Net Debt, Company A = $0mm
  • Net Debt, Company B = $600mm
  • Net Debt, Company C = $1.2bn

Once we add the $4bn in market cap to the corresponding net debt value of each company, we get different enterprise values for each.

Enterprise Value (TEV)

  • TEV, Company A = $4bn
  • TEV, Company B = $4.6bn
  • TEV, Company C = $5.2bn

The important takeaway is the impact of different capital structures (i.e. the net debt amount) on equity value and enterprise value.

Since we know that equity value is NOT capital structure neutral while enterprise value IS capital structure neutral, it’d be a costly mistake to assume that each company is worth the same value based on solely their equivalent market caps of $4bn.

Despite their identical market caps, Company C has an enterprise value that is $1.2bn greater than that of Company A in comparison.

Step 4: Enterprise Value to Market Cap Calculation

In the final section of our tutorial, we’ll practice the calculation of equity value from enterprise value.

After linking the enterprise values for each company from the prior steps, we’ll subtract the net debt amounts this time around in order to arrive at equity value.

From the screenshot posted above, we can see that the formula is simply the enterprise value minus the net debt. But since we have switched the sign convention when linking to the hardcoded values, we can simply just add the two cells.

The market capitalization that we are left with for each company is $4bn once again, confirming our prior calculations thus far were in fact correct.

Market Cap Calculator

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