Two of the metrics analysts use to estimate the value of a company are market capitalization (or market cap) and revenue. According to the Financial Industry Regulatory Authority, market cap is a company’s total market value based on the number of shares it has issued and the current stock market price per share. Revenue is the gross earnings from sales and does not depend on the share price. The market cap to revenue (MC/R) ratio is a blunt indicator of whether a company’s stock price correctly reflects its enterprise value.
What Is Market Capitalization?
A company’s market cap depends on the total number of outstanding shares, which are the shares held by shareholders and restricted shares owned by company management. The number of outstanding shares is equal to the number of shares authorized by the board of directors minus shares held by the corporate entity, known as treasury stock.
Outstanding Shares = Authorized Shares – Treasury Shares
Market Cap = Outstanding Shares x Current Price/Share
For example, a company with 2 million outstanding shares trading at a current share price of $20 has a market cap of 2 million x $20, or $40 million.
You might think a company’s market capitalization is the amount of cash a buyer would need to purchase the company. However, the figure excludes important valuation components, including liquid assets (i.e., cash and cash equivalents), liabilities (what the company owes) and growth potential (the ability to generate higher profits and production).
Therefore, market cap is too simplistic to reveal a corporation’s actual value to an outside buyer. It does help to categorize a company’s size, such as large cap ($10 billion or more) or small cap ($300 million to $2 billion). For example, Nasdaq explains that the Dow Jones Industrial Average comprises 30 large-cap stocks of blue-chip, well-established companies, whereas the Russell 2000 is a stock index of small-cap companies.
Several factors affect a company’s market cap, including:
- Substantial changes in share prices, whether up or down
- Additional issuances of new shares
- A company purchasing treasury shares in the secondary market
- The exercise of warrants, which increases the number of outstanding shares
- Cash dividends, when paid, reduce a company’s share price and therefore impact the market cap
What Is Revenue?
Revenue is independent of market cap. It is the amount of money a company earns through its products and services (as opposed to gains from selling noninventory assets, such as a production plant). Factors that affect revenue include the prices of a company’s goods and services, the amount of inventory available for sale, the demand for the company’s offerings and the effectiveness of the company's product distribution.
How to Calculate the Ratio
To calculate the MC/R ratio:
- Look up the company’s outstanding shares, which are listed as capital stock in the stockholders’ equity section of the balance sheet. Include all classes of outstanding common and preferred shares.
- Check the current prices of the company’s shares. You can do this through a simple online search.
- Multiply the outstanding shares of each stock class by its current price and sum the results, giving you the market cap.
- Find the company’s annual sales revenue, which is available online and on the company’s income statement in its annual report.
- Calculate the MC/R ratio as follows: Market Cap / Revenue = (Outstanding Shares x Price Per Share) / Sales Revenue. For example, a company with a $40 million market cap and $10 million in sales has an MC/R ratio of 4.0.
What Is a Good Market Cap to Revenue Ratio?
It only makes sense to compare MC/R ratios between similar companies in the same industry due to differing capital requirements. The ratio is good if it exceeds the average value for the set of competing companies. The MC/R ratio is also called the aggregate price-to-sales ratio, which is total corporation market cap divided by total corporate sales.
Is Higher Market Cap Better?
Large market caps are not necessarily better than small ones, as company size does not always correlate with net profits or growth potential. More important is a growing market cap coupled with increasing profits, indicating the company has a strong market position. On the other hand, declining revenues can be a red flag independent of market cap.
What if the Market Cap Is Less Than the Revenue?
Market cap ratios greater than 2.0 are considered strong, but the interpretation varies by industry. When the market cap is less than revenue, then the MC/R ratio is less than 1.0, possibly indicating potential value (i.e., a low stock price coupled with solid sales) that is as yet unrecognized by the investors. But for the MC/R ratio to be an accurate value indicator, it must be interpreted in the context of profit margins, debt and growth prospects.
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.