Market capitalization represents the market value for an entire company. Investors can compare market cap to financial data to evaluate the price relative to fundamental returns. Market cap is also useful for identifying the type of stock and setting appropriate growth, risk and dividend expectations.
Popular valuation ratios that take market capitalization as an input include price to earnings, price to free cash flow, price to book value and enterprise value to EBITDA. Price to earnings is calculated by dividing market cap by 12-month net income and can reference trailing earnings or projected future earnings. Price to free cash flow is calculated by dividing market cap by 12-month free cash flow. Free cash flow can be calculated by subtracting capital expenses from cash flow from operations, and this ratio can also use historical or projected returns.
Price to book value is calculated by dividing market cap by total shareholder equity. Shareholder equity is the balance of total assets and liabilities. The enterprise value to EBITDA ratio functions similarly to the price to earnings ratio. Enterprise value is calculated by summing the market value of common and preferred equity, minority interest and net debt. EBITDA refers to earnings before interest, taxes, deprecation and amortization, and measures operational returns in the short term.
Market capitalization is used to set investor expectations and shape investment strategy. There is no official barrier for different categories of stocks based on size, but large caps are often companies with market caps over $10 billion, mid cap is $2 billion to $10 billion and small cap refers to companies under $2 billion. Different types of investment strategies focus on the various market cap groups, and different valuation methods are applied depending on company size. Very large market caps are usually associated with mature, low-growth companies that pay dividends. Small caps are often growth companies with higher-risk profiles and generally do not pay dividends.