Why is a stock that cost $50 less than another stock priced at $10?
This question opens a point that often trips up beginning investors: The per-share price of a stock is thought to convey some sense of value relative to other stocks. Nothing could be farther from the truth.
In fact, except for its use in some calculations, the per-share price is virtually meaningless to investors doing fundamental analysis. If you follow the technical analysis route to stock selection, it’s a different story, but for now let’s stick with fundamental analysis.
The reason we aren’t concerned with per-share price is that it is always changing and, since each company has a different number of outstanding shares, it doesn’t give us a clue to the value of the company. For that number, we need the market capitalization or market cap number.
The market cap is found by multiplying the per-share price times the total number of outstanding shares. This number gives you the total value of the company or stated another way, what it would cost to buy the whole company on the open market.
Here’s an example:
Stock price: $50
Outstanding shares: 50 million
Market cap: $50 x 50,000,000 = $2.5 billion
To prove our opening sentence, look at this second example:
Stock price: $10
Outstanding shares: 300 million
Market cap: $10 x 300,000,000 = $3 billion
This is how you should look at these two companies for evaluation purposes. Their per-share prices tell you nothing by themselves.
What does market cap tell you?
First, it gives you a starting place for evaluation. When looking a stock, it should always be in a context. How does the company compare to others of a similar size in the same industry?
The market generally classifies stocks into three categories:
- Small Cap under $1 billion
- Mid Cap $1 - $10 billion
- Large Cap $10 billion plus
You will also use market cap in your screens when looking for a certain size company to balance your portfolio.