Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Capitalization

What it is:

In the business world, capitalization has two meanings. The first meaning, also called market capitalization, refers to the value of a company's outstanding shares. The formula for market capitalization is:

Market Capitalization = Current Stock Price x Shares Outstanding

It is important to note that market cap is not the same as equity value, nor is it equal to a company's debt plus its shareholders' equity (although that too is sometimes referred to as simply the company's capitalization).

The second meaning of the term relates to the act of accounting for a cost as an asset instead of an expense.
 

How it works (Example):

Let's assume Company XYZ has 10 million shares outstanding and the current share price is $9. Based on this information and the formula above, we can calculate that Company XYZ's market capitalization is 10 million x $9 = $90 million.

Companies with less than $1 billion of market cap are generally regarded as "small cap" companies. "Large cap" companies usually have at least $8 billion of market cap.

In the second use of the term, let’s assume Company XYZ creates a new drainage system to prevent run-off rainwater from flooding the neighbor’s business. Because the costs associated with the change constitute an addition to the property and allows it to use the property as a concert venue, Company XYZ can capitalize those costs. So, instead of recording the costs as an expense on the balance sheet, which would lower the company’s net income, Company XYZ records the costs as an asset on the balance sheet. These assets then depreciate, which has a much smaller effect on net profits.

Why it Matters:

Capitalization reflects the theoretical value of a company, but this is usually not what the company could be purchased for in a normal merger transaction. One reason for this is that the value of material nonpublic information, management changes, operating synergies between the acquirer and the company, and other intangible factors may not be reflected in the stock price or the financial statements.

In the accounting sense, capitalization is good for companies that want to keep net income as high as possible; however, it’s not  as good for companies that want to pay as little in taxes as possible (business expenses are tax-deductible; capitalized assets are not).

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