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Morningstar.com's Interactive Classroom

Course 302
Market Capitalization

Introduction

Which company is bigger, Barnes & Noble BKS or Amazon.com AMZN? Barnes & Nobel generated more than $3 billion in sales from the fourth quarter of 1998 through the third quarter of 1999, the most of any U.S. bookseller. Amazon's sales during the same period were $1.2 billion, less than half as much. But from another perspective, Amazon was more than 10 times bigger: Its market cap as of mid-November 1999 was close to $25 billion, compared with about $1.5 billion for Barnes & Noble. Why the difference? Market capitalization (or market cap, for short) is the total dollar value of a company's stock, or the price per share times the number of outstanding shares. The most important thing determining this value is not the company's current size in terms of sales but the market's perception of its future prospects. If investors think a company will grow very fast, they are likely to bid up its share price.

Market Cap Reflects the Market's Opinion

Amazon is a great example of this process. As the company's stock soared more than 1,000% in 1998, Amazon's market cap zoomed past those of Barnes & Noble and Borders BGP, though it does only a fraction of their business. But its sales have been growing at an incredible clip, and many people see Internet commerce as the wave of the future. Amazon's market cap reflects this optimism about the company's future. On the other end of the spectrum, bad news can cause a company's market cap to sink. When network supplier Ciena CIEN revealed in early 1998 that it wouldn't get a major contract from AT&T T, its stock price (and thus its market cap) plunged 45% in a single day. Ciena's present size in terms of sales hadn't changed, but the future of its earnings was suddenly a lot less certain. Even without explicit bad news, general pessimism can knock down market caps considerably. In the bear market of 1973 to 1974, more than 40% of the Dow Jones Industrial Average's market cap simply melted away, even though most companies' fundamentals didn't change much.

Market Cap among Sectors

The relationship between market cap and the size of the business varies widely not just among specific stocks but among broader sectors as well. For example, utilities are seen as stable companies without much room to grow. As a group, their market caps average about 1.7 times book value and 1.3 times sales; a utility such as Ipalco IPL, with valuations more than twice that, is a relative highflier within the sector. In contrast, the optimism about many technology stocks is greater. As of late 1999, the average technology stock was priced at about 15 times book value and nine times sales, and a tech company with valuations like Ipalco's would be a relative bargain. Within the tech sector, Internet stocks are much pricier than their average tech peer; their market caps are often more than 50 times book value and 20 times sales. Just about everybody, including Morningstar, defines the size of a company primarily in terms of its market cap. So it is important to realize that market cap measures the size of people's expectations about a company's future, not the present size of the company's actual business. Some large-cap stocks are established businesses with lots of sales and profits; others are hot newcomers with investor expectations higher than actual revenues. It's always a good idea to look beyond market cap to see whether it is based on the company's prospects or its current condition.

Quiz 302
There is only one correct answer to each question.

1 Market capitalization is equal to:
a. Shares outstanding multiplied by revenue.
b. Revenue multiplied by price per share.
c. Shares outstanding multiplied by price per share.
2 Which of the following is the most important factor determining a company's market cap?
a. The company's earnings over the past four quarters.
b. The market's opinion of the company's future.
c. The amount the company pays out in dividends.
3 If a company's market cap drops by 50%, this means:
a. Its fundamentals haven't necessarily changed.
b. Its revenue has dropped.
c. It automatically has 50% fewer shares outstanding.
4 If a utility and a technology company both have a market cap of $1 billion, which is likely to have a higher book value?
a. The utility.
b. The technology company.
c. Their book values will be the same.
5 Which of the following is <em>not</em> likely to reduce a company's market cap?
a. An announcement that the company has lost a contract accounting for half of its expected revenues in the coming year.
b. A warning that the company's earnings growth will slow down considerably from what had been expected.
c. An announcement that the company is starting a new online unit.
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