How Are a Company's Stock Price and Market Cap Determined?

A company’s worth—or its total market value—is called its market capitalization, or market cap. A company’s market cap at any given time can be determined by multiplying its stock price by the number of shares outstanding.

Therefore, any significant change in a stock price results in an equal percentage change in the company’s market cap. This is one of the reasons why investors are so concerned with stock prices. A $0.10 drop in a stock price results in a $100,000 loss on paper for a shareholder with one million shares.

Key Takeaways

  • A company’s market capitalization—also called its market cap—is a straightforward measure of the company’s market value.
  • Market cap is calculated by taking the current share price and multiplying it by the number of shares outstanding.
  • For example, a company with 50 million shares and a stock price of $100 per share would have a market cap of $5 billion.
  • Stocks are often classified according to the company’s respective market value, Big caps are companies that have a large market value while small caps have a small market value.

How Is Share Price Determined?

Broadly speaking, prices in the stock market are driven by supply and demand. This makes the stock market similar to other economic markets. When a stock share is sold, a buyer and seller exchange money for share ownership. The price for which the stock is purchased becomes the new market price. When another share is sold, this price becomes the newest market price.

There are various techniques and formulas that can be used to predict the future price of a company’s shares. Called dividend discount models (DDMs), they are based on the concept that a stock’s current price equals the sum total of all its future dividend payments (when discounted back to their present value). By determining a company’s share by the sum total of its expected future dividends, dividend discount models use the theory of the time value of money (TVM).

A company’s market capitalization is calculated by multiplying its share price by the number of shares outstanding:

Market Capitalization = share price x number of shares outstanding

A company’s market cap is first established in an initial public offering (IPO). In preparing for this process, a company pays a third party (typically an investment bank) to determine the value of a company, and recommend how many shares to offer to the public and at what price. For example, a company whose value is estimated at $100 million may want to issue 10 million shares at $10 per share.

Once a company goes public and its shares start trading on a stock exchange, its share price is determined by supply and demand in the market. If there is a high demand for its shares, the price will increase. If the company’s future growth potential looks dubious, sellers of the stock can drive down its price.

For example, suppose that Microsoft (MSFT) is trading for $71.41 on Sept. 8, 2022, and has 7.7 billion shares outstanding. Assume also that the company is valued at $71.41 x 7.7 billion = $550 billion. Meanwhile, Meta (META), formerly Facebook, has a $162.06 stock price and 2.69 billion shares outstanding (market cap = $435.5 billion). As of this date, Meta is worth less than Microsoft.

Misconceptions About Market Capitalization

Although it is often used to describe a company (e.g., large cap vs. small cap), market cap does not measure the equity value of a company. Only a thorough analysis of a company’s fundamentals can do that.

Market capitalization is an inadequate way to value a company because its market price is not necessarily a reflection of how much a piece of the business is worth. Shares are often over- or undervalued by the market.

Market price shows only how much the market is willing to pay for its shares, not how much it is actually worth. 

Even though market cap measures the cost of buying all of a company’s shares, it does not determine the amount the company would cost to acquire in a merger transaction.

While market cap is often used synonymously with a company’s market value, market cap really refers only to the market value of a company’s equity, not its market value overall, which would include the value of its debt or assets.



Image and article originally from www.investopedia.com. Read the original article here.