What Is Market Cap? A Foolish Analyst's Plain-English Guide to the Metric That Separates Winners From Losers.

What makes a company big or small? There are lots of ways to measure the value and size of companies. But one of the most important ways is market cap.

What is market cap? It's short for "market capitalization." This is a fancy way of saying the overall size of a company's estimated market value based on what investors are willing to pay for the company's shares.

Market cap is one of the most used and frequently discussed ways of measuring and understanding the value and size of a publicly traded company. When investors say that a company is a "billion-dollar company" or "trillion-dollar company," they're usually talking about market cap.

Learning more about how market cap works and why it matters for choosing stocks can help you be a better-informed investor. Let's look at the big picture of market cap and see how it affects our investments.

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What is market cap -- and how is it calculated?

Market cap is a way of measuring the overall value of a publicly traded company. It shows investors the approximate size of a company based on share price and total shares being traded in the market. It's one of the most useful metrics for estimating a company's total value in dollars.

Market cap is calculated by taking the total number of a company's shares outstanding and multiplying that figure by the price per share. As an example, if a company has 10 million shares of stock outstanding, and the stock price is trading at $100 per share, that company's market cap is 10 million x $100, or $1 billion.

Market caps are constantly changing. Every time a company's stock price goes up or down, the company's market cap goes up or down with it. If a company issues new shares of stock (increasing the number of shares outstanding) or does a stock buyback (which reduces the number of shares outstanding), this also can affect the market cap.

Why market cap matters for investing

Investors follow share prices, price-to-earnings (P/E) ratios, analyst ratings, earnings estimates, and other metrics to try to understand the value of different stocks and decide which ones to buy. Market cap is a big-picture way of understanding how a stock fits into the larger investment universe. Grouping stocks of similar sizes and valuations together can help investors organize their portfolios.

Market cap is important for investing because it gives an easy, comparable way to understand companies' advantages, growth potential, and possible risks. Some investors might only want to buy the largest, most successful companies. Others might prefer to invest in smaller companies that have potential for faster growth. Others might want to buy stocks of all market-cap sizes with all-cap index funds or total stock market exchange-traded funds (ETFs).

What are large-cap, mid-cap, and small-cap stocks?

Large-cap companies are typically defined as having market caps of $10 billion or higher. These companies tend to be well established and often pay dividends.

As of this writing, some of the largest companies by market cap include:

• Nvidia (NASDAQ: NVDA): $5.6 trillion market cap
• Apple (NASDAQ: AAPL): $4.9 trillion market cap
• Alphabet (NASDAQ: GOOG)(NASDAQ: GOOGL): $4.2 trillion market cap

Not many companies are successful enough to reach the large-cap level. If you would rather buy stocks of smaller, up-and-coming businesses, small-cap stocks will let you do that. Small-cap stocks are generally defined as companies with market caps of $300 million to $2 billion. Because small caps are smaller, younger, less-established companies, they have potential for rapid growth -- but can also be riskier than large-cap stocks.

If you want to own a middle ground between small caps and large caps, mid-cap stocks can be a good choice. Mid-cap stocks are defined as having market caps of $2 billion to $10 billion. Because of their size and risk profile, mid-caps can be lower-risk than small caps while also offering some more growth potential than large caps.

How to choose stocks based on market cap

If you want to choose investments based on market cap, one easy way to do that is to buy index funds. These funds let you own hundreds or thousands of stocks all at once, which can diversify your risks.

One of the most popular large-cap ETFs is the Vanguard S&P 500 ETF (NYSEMKT: VOO). This fund holds only the stocks of the 500 largest publicly traded companies in the U.S. It's delivered average annual returns of 15.3% during the past 10 years, and about 13.8% in the past five years.

An example of a mid-cap stock ETF that could be worth considering is the iShares S&P Mid-Cap 400 Value ETF (NYSEMKT: IJJ). This fund holds 304 mid-cap value stocks. This fund has underperformed the S&P 500 in recent years, with average annual returns of about 10.2% during the past 10 years and about 8.4% for the past five years.

What if you want to buy lots of small-cap stocks? The iShares Russell 2000 ETF (NYSEMKT: IWM) is an easy way to buy a Russell 2000 index fund of 1,986 small-cap stocks. This small-cap ETF has also underperformed the S&P 500 in recent years, with average annual returns of about 10.5% during the past 10 years and about 6.7% in the past five years.

Keep in mind that no type of stock is risk-free, and investing based on market cap doesn't guarantee any future returns. Large-caps can, and have, outperform small caps and mid caps. No one knows which size of market cap are the best stocks to own for the future.

Ben Gran has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Alphabet, Apple, Nvidia, and Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.