The stock market is a strange beast that baffles and intrigues investors in equal measure. With an increasing number of Indians investing in the stock market by way of equity and mutual fund investments, two fundamental questions many investors have are: ‘How does the stock market work?’ and ‘How are stock prices determined?’
Understanding the basics of equity pricing and its role in deriving a company’s market capitalization is essential before entering equity investing. Read on to learn more about how stock prices are determined and what market cap means.
How are stock prices determined?
Understanding how stock prices are determined involves deciphering the interplay between supply and demand economics, the firm’s performance, economic conditions, stock market sentiment, industry trends, global events, and regulatory frameworks.
Investors can study these factors to make informed investment decisions when navigating the equity markets. We will discuss some of these factors that help derive equity prices.
• Demand and supply
Equity prices are a function of demand and supply. If a stock goes up, it sees buying pressure or increased demand. If the stock goes down, it witnesses selling pressure or a decrease in demand. While demand-supply is simple economics, various factors impacting demand and supply make equity prices fluctuate frequently. Here are the factors that can influence the demand for a stock:
• Firm’s performance
A company’s financial health significantly impacts its stock price. Key indicators include earnings reports, revenue growth, and profit margins. Positive financial results often boost investor confidence and lead to higher stock prices, while dismal results can build selling pressure, leading to price decline.
• Economic conditions
The overall state of the economy plays a crucial role in equity pricing. Healthy GDP growth rates boost investor confidence, lead to increased buying, and positively impact prices. Conversely, high inflation or rising interest rates can hurt corporate profits and reduce stock prices.
• Investor sentiment
Investor sentiment is vital in determining stock prices. News, social media trends, interpretation of company results, and investor perception of the firm’s growth potential can all drive stock prices. Positive developments can boost investor confidence, leading to sustained price rallies, while negative news can trigger selling, leading to price drops.
• Global events
The global financial system is interconnected. Geopolitical events, such as wars or changes in trade tariffs, can create uncertainty, impacting market confidence and stock valuations. Economic policies of major economies such as the US also play a role in influencing Indian stocks.
What does market cap mean?
Market cap, or market capitalization, is a vital evaluation metric derived by multiplying the company’s current share price by the number of shares outstanding. The metric helps evaluate the firm’s stability, growth potential, and investment risk.
How is market cap determined?
The market cap of a company can be determined by using the following formula:
Market Capitalization = Current Share Price * Total Number of Outstanding Shares
For example, Company X has 10 lakh outstanding shares, and its current share price is Rs. 90, the market cap of Company X will be –
Market Cap = 90 * 1,000,000= Rs. 90,000,000
Components of market cap calculation
Here are the two components of market cap:
1. Current Share Price
The market price is the price at which a single stock of the company is available for buying or selling on the stock exchange. As discussed, the share price is determined by the demand-supply dynamic and can be impacted by investor sentiment, company performance, etc.
2. Outstanding Shares
All the shares currently held by shareholders, including those held by promoters, retail investors, and institutional investors. Outstanding shares do not include treasury shares held by the company itself.
The importance of market cap
The market capitalization of a listed company serves several important functions:
• Company Classification:
Listed companies are classified based on market cap. Here are the three categories of listed companies based on market capitalization:
• Large-cap: Companies with a market cap over ₹20,000 crores are considered large-cap and typically represent more stable investments.
• Mid-cap: Companies with a market cap between ₹5,000 crores and ₹20,000 crores are classified as mid-cap and offer a balance between growth potential and risk.
• Small-cap: Companies with a market cap below ₹5,000 crores are considered small-cap and can be more volatile but may offer higher growth potential.
• Investment Strategy
Investors use market cap to define their investment preferences and indicate their risk appetite. Large-cap stocks are generally viewed as safer investments due to their stability. Small-cap stocks may provide opportunities for significant growth while having increased volatility compared to large-cap stocks.
• Market Sentiment Indicator
Equity price is a determining factor in calculating market cap. A company with a rapidly increasing market cap generally means its stock is in high demand and stock price is steadily rising. Changes in the market cap can reflect investor sentiment about a company’s prospects. A rising market cap indicates positive sentiment and confidence in the company’s performance.
Misconceptions about market capitalization
While market capitalization is a widely used classification metric, there are some misconceptions about market capitalization.
Investors often assume that the market cap reflects the intrinsic value of the company or equity. However, this is not the case, as the market cap only indicates how much investors are willing to pay for a company’s shares, not the actual worth of the company.
Market capitalization is an inadequate metric to value a company, as its market price does not necessarily reflect its worth. Market sentiment often overvalues or undervalues shares.
Therefore, while market capitalization can help categorize a company, it should not be construed as an indicator of its fair value.
Which companies have the largest market cap?
Here are the top 10 Indian companies by market capitalization:
| Rank | Company | Market Cap (₹ Cr) |
| 1 | Reliance Industries Ltd. | 1661369.42 |
| 2 | Tata Consultancy Services Ltd. | 1369717.48 |
| 3 | HDFC Bank Ltd | 1294152.82 |
| 4 | Bharti Airtel Ltd. | 934223.77 |
| 5 | ICICI Bank Ltd. | 870580.24 |
| 6 | Infosys Ltd. | 753783.47 |
| 7 | State Bank of India | 643955.96 |
| 8 | Hindustan Unilever Ltd. | 526684.38 |
| 9 | Bajaj Finance Limited | 520466.75 |
| 10 | ITC Ltd. | 501750.43 |
Source: bseindia.com All data as of 24 Feb, 2025
What leads to an increase in market cap?
Market cap is determined by multiplying the stock price by the number of outstanding shares. Any change in the stock price impacts market capitalization. An increase in stock prices raises the market cap, while a fall in share prices causes it to fall.
Market cap can also fluctuate when companies go through buyback or if new shares are made available.
Can market cap be used as a risk indicator?
It is widely accepted that stocks with larger market caps are less risky, while small- and mid-cap stocks are more volatile and thus riskier.
But this might not always be true. A large-cap stock weighed down by debt or in turmoil due to management changes can suddenly turn riskier than previously assumed.
Likewise, a small-cap stock with steadily increasing earnings and little to no debt might be a less risky investment than some of its large-cap counterparts.
Conclusion
Understanding how stock prices and market capitalization are determined is crucial for investors navigating the complex landscape of financial markets. Share prices fluctuate based on supply and demand dynamics influenced by fundamental factors, technical analysis, and investor sentiment. Thus, market capitalization is essential for assessing company size and potential investment risks.
While they provide valuable insights into corporate health and performance trends, investors must look beyond these figures—considering broader economic indicators and company fundamentals—to make well-rounded investment decisions that align with their financial goals.
