Key Points
Beginner investors often use the share price figure to determine a stock’s size or relative “cheapness,” but this is a major mistake.
Instead, use market cap as your starting point to assess a stock’s valuation and long-term potential.
Utilize more sophisticated valuation metrics, like P/E and EV/EBITDA, when analyzing whether a stock is undervalued or overvalued.
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Many people starting out in investing may look at a stock’s share price and assume that this number can tell them whether a stock is large or small and whether it is cheap or expensive. However, in actuality, that is far from the case. While the question of whether a stock is cheap or expensive can be subjective and based on numerous valuation and growth metrics, determining whether a stock is big or small is primarily a matter of assessing its market capitalization (market cap).
Market cap represents the market value of a company’s equity. Want to know how to calculate the market value of a firm’s equity? Take the stock price and multiply it by the number of shares outstanding.
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Market cap is far from the only metric one should consider before investing in a stock, but assessing market cap can give you a high-level view of a company’s size and its realistic long-term upside potential before considering other factors.
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Share price is a fairly arbitrary number
There are companies with large market caps but low share prices and companies with low market caps but high share prices.
For example, insurer White Mountains Insurance (NYSE: WTM) trades at over $2,000 per share yet has a market cap considered midsized, around $4.8 billion. In contrast, Brazil-based brewing company Ambev SA (NYSE: ABEV) is a large-cap stock, with a market cap of nearly $44 billion, but trades at under $3 per share and is technically within the penny-stock category.
Another example of how share prices can be arbitrary is seen among the “Magnificent Seven” stocks. Among the Magnificent Seven, consisting of most of the largest technology companies by market cap, Meta Platforms (NASDAQ: META) may have the highest stock price, at around $750 per share, but its $1.9 trillion market cap is less than half that of Nvidia‘s (NASDAQ: NVDA), which trades for around $225 per share but has a market cap of over $5 billion.
A major reason for this variance in stock prices and market caps is stock splits. Companies like White Mountains are one of the more extreme examples of what happens when you don’t implement stock splits, while stocks like Ambev are a prime example of what happens when a stock experiences a severe price drop following a stock split.
What market cap can tell you about potential upside
To fully judge valuation, consider using metrics like price-to-earnings (P/E); enterprise value-to-EBITDA (earnings before interest, taxes, depreciation, and amortization), known as EV/EBITDA; and long-term growth forecasts. That said, market cap can give you a general idea of how far a stock can run, especially for megacap stocks, with market caps exceeding $200 billion.
This brings us back to Magnificent Seven names like Nvidia. Thanks to the generative artificial intelligence (GenAI) boom, Nvidia has surged over tenfold over the past five years. However, with its over-$5 trillion market cap, barring a scenario in which AI changes the paradigm far more than already anticipated, it’s going to take considerably more time for Nvidia to scale up its valuation another tenfold to $50 trillion.
That said, going down the market cap scale, one can see that the smaller the size, the greater the long-term appreciation, at least in theory. Starting from the bottom, successful micro-cap stocks, or stocks with market caps under $250 million, can, in time, scale up into small-cap stocks, or stocks with market caps between $250 million and $2 billion. Small caps can, in time, scale into mid-cap stocks with a $2 billion to $10 billion market cap, or even into large caps with a $10 billion to $200 billion market cap. In turn, today’s large caps could scale into tomorrow’s megacaps.
How investors should consider market cap
Ignore market cap at your own peril, but keep in mind that this metric alone isn’t the ticket to stock market success. With smaller market caps comes greater volatility, and in some cases, large, venerable companies that fail to adapt to changing economic trends can find themselves moving down in market-cap class as well.
That said, when making an initial assessment of a stock, be sure to consider the market cap more greatly than the stock’s current share price.
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Thomas Niel has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Meta Platforms and Nvidia. The Motley Fool has a disclosure policy.
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