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Understanding Market Capitalization and Enterprise Value

Before choosing a stock to invest in, investors study and analyze a lot of metrics to make the correct choice like the P/E ratio, Price-to-Book Value, etc. Among these metrics, there are two metrics that help investors to determine the size and value of a company. Understanding the size of a company can help you take a better and informed investment decision. In this article, we will understand what is market capitalization and enterprise value and how can it benefit investors.

Market Capitalization

In simple words, market capitalization is the total value of a company in the stock market. This metric can be calculated by multiplying the current market price with the number of outstanding shares of the company. Market capitalization, also known as market cap, helps investors to make smart investment decisions while creating a long-term investment plan. To understand this in a better way, let’s take an example.

Shopify is a Canadian e-commerce company, the current market price of Shopify i.e. on 26th February, 2021 was USD 1,280.97 and it has 111.06 M outstanding shares. That means, the market cap of Shopify is US$ 158.6 B. In other words, this is the price someone has to pay to buy every stock of the company that are open to public.

Based on this metric, companies are divided into small cap, mid-cap and large cap. According to learningbull, market cap helps investors to decide a company’s size, which can be an important aspect to consider while investing. The size of a company can tell you a lot about what one should expect while buying their stocks.

Large-Cap Companies– These companies have a market capitalization above $10 billion. Generally, such organizations are market leaders with a huge presence and are easily identifiable companies.

They are considered safer investment options because they are stable and well-established in the market. Further, taking a long-term view on these stocks might give you reasonable returns with significantly lower risks. Another advantage of investing in large-cap stocks is that several companies offer consistent dividend payments.

Mid-Cap Companies– Companies that are valued at a market cap of between $2 billion and $10 billion are considered mid-cap stocks. Mid-cap stocks is a great way for investors to diversify risk, as unlike small-cap stocks that provide growth potential and large-cap that provide stability, they provide the best of large-cap stocks and small-cap stocks.

Small-Cap Companies– Small-Cap stocks companies have market caps between $300 million and $2 billion. These companies are very young companies that means that the stocks have a high potential for growth and returns. This also means that it carries higher risks than large-cap and mid-cap companies. Investors need a lot of patience and have to face extreme stock volatility to gain from capital appreciation. The returns of good small-cap companies can be worth the wait.

Enterprise Value

Enterprise value is the metric used to determine the total value of a company. Although it sounds similar to market cap, enterprise value considers important factors such as preferred shares, debt, cash and equivalents.

According to CFI, enterprise value is very useful in mergers and acquisition situations, especially with controlling ownership interests. In addition, it is useful for comparing companies with different capital structures because a change in capital structure will affect the amount of enterprise value.

The simple formula to calculate EV is:

Enterprise Value= Market Capitalization+ Market Value of Debt- Cash and Equivalents

This means that supposing you want to buy 100% of a company, the enterprise value is the cost you have to pay to acquire it. In enterprise value, the debt is included as the company is yours. Similarly, the cash is subtracted as along with ownership; the cash becomes yours.

According to thebalance, enterprise value provides a more accurate estimate of takeover cost than market capitalization because it includes several other important factors, such as preferred stock, and debt (including bank loans and corporate bonds), and it backs out cash reserves, which don’t factor into the latter metric. 

Enterprise value helps investors to identify companies the market has undervalued. A company with large market cap, solid earnings and good dividends might seem attractive in the market, but the enterprise value of a company will help you understand the debt company carries, which may sometimes pose as a big problem in the future.

For example, as of today, the enterprise value of Enbridge is 168.18 B, which is the addition of market cap, debt subtracted by cash and equivalents. Whereas, the market cap of the company is 87.06 B.

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