Understanding Market Cap

vevaone (25)in #cryptocurrency • 6 years ago (edited)

I spend a lot of time talking to people with various levels of experience in finance and blockchain technology, and certain topics come up over and over again. One of the most common, and the most misunderstood, is Market Cap.

What is Market Cap?

Market capitalization, or market cap, is often used colloquially to mean something like “total money invested.” For example, someone might tell me that “The market cap just dropped from 500 billion dollars to 400 billion dollars! 100 billion dollars were pulled out of the market in the last three days — that’s like ten million people each pulling out ten grand. We’re in a bear market, for sure. For sure.” But what, exactly, is market cap? It’s actually not an indicator of the amount of money people have invested in the market. The market cap may be $400,000,000,000, but that doesn’t mean there is actually 400 billion dollars in the market. Similarly, just because the cap dropped 100 billion doesn’t mean that that investors have pulled 100 billion out of the market. Market capitalization is “the total dollar market value of a company’s outstanding shares”. In layman’s terms, it is calculated by multiplying the market value per share by the price per share. Market cap is better understood as an indicator of a company’s size, rather than the total dollar value invested in a company. In the crypto world, it’s calculated by multiplying the available/circulating token supply (“shares”) by the price per token (“market value”).

Does this Distinction Matter?

The term “market cap” can be misleading. To illustrate, imagine the following: CapCoin is worth $1 and there are 100 tokens available. All tokens have been sold, so the total investment in CapCoin is $100. In this case, the market cap is also $100. But what if the price starts rising?

If 5 holders put their tokens up for sale for $2, and people buy them, each token has a nominal value of $2. Thus, there was $100 invested in the market. Five people sold their original $1 stake, but five additional dollars entered the market, giving a total investment of $105. So, in this scenario, what’s the market cap? At this point, there are 100 tokens valued at $2 each… so the market cap is $200. That’s right — since they’re all the same, they’re all assumed to be worth the last selling price. This is obviously a different amount than the amount actually tied up in the market (i.e., $105).

Now, what if CapCoin sees a meteoric rise in price — how could this happen? Here’s one scenario: imagine we are back at square one, and CapCoin is worth $1: $100 invested, $100 market cap. Now, imagine that one rogue holder (Alice) sells her token to Bob for $5 — suddenly, there is $105 invested, and a market cap of $500. And Bob sells the token to Charlie for $10, and Charlie sells it to Daria for $20, and Daria sells it to Ernie for $100. The total invested is $199, the market cap is a whopping $10,000, and interestingly, the volume is 4 tokens sold (which, in dollar value, is $400). But only one coin has changed hands, and very little new money has entered the market!

The CapCoin scenario is useful in understanding what may be happening in the real market with Bitcoin (or any other token). The truth is, we don’t know exactly how much money is in the market. There are currently ~17,000,000 Bitcoins in circulation, and the price is, as of the time of this writing, hovering right around $9,000 — giving a market cap of about 160 billion. It’s important to realize that the market cap would be exactly the same if the market was made up of 16,999,999 Bitcoins purchased for $10 total, just sitting untouched in someone’s wallet, and the one remaining Bitcoin was being traded back and forth for ~$9,000. The volume could be just as high, and the market cap could still be $160 billion, despite the fact that the total amount of money in the market is still around $9,000.

Conclusion

Of course, it’s unlikely this is what’s happening. We can see that a good number of Bitcoins are constantly changing hands, and that the market seems, for the most part, healthy and robust. On the other hand, it is also true that there is nowhere near as much as $400,000,000 (the market cap at the time of this writing) actually invested in the market. Estimates vary, but most projections suggest actual investment is in the $12–15 billion range.

All that said, it’s likely that both the market cap and market volume are grossly inflated. A fair amount of the inflation results from a relatively small number of individuals trading the same coins back and forth. Price fluctuations also generate some amount of inflation, as well. So, just remember: significant drops (or rises) in the market cap over a short period of time isn’t meaningless — but it may not be as dire as it seems at first blush.