One of the most common terms you will hear about is market capitalization or market cap. It continues to be considered one of the reliable ways in which a company’s worth is evaluated. And it is a simple and transparent calculation.
So what is “Market Cap”? The short answer is that the market cap is the value of the shares of a publicly traded company and is determined by multiplying the number of outstanding shares by the price of the share.
Here is an example for Costco Wholesale (NASDAQ: COST):
- Number of outstanding shares – 441.52 million
- Price of a share – $541.30
- Market cap of Costco – 441.52 million x $541.30 = $238.99 billion
You may be wondering now, why this matters or why investors care about the share numbers and values. The short answer it can tell about the size of the company, but it also indicates much more. In this short article, I will explain why “Market Cap” matters and should be one of the first things investors look at.
The relevance of market cap
Market cap has been used as a measure of the size of the traded company which, in turn, holds several clues about what to expect from the company.
With a business that has grown over time and weathered the vagaries of cycles, large companies are expected to have a business that is mature and a model that is stable. In terms of rate of growth, since they already have a large base, and have, presumably, taken advantage of available opportunities, the growth potential may be limited.
Smaller companies typically have greater and faster growth prospects, but may not have yet got a chance to prove themselves and their business model under adverse conditions. Hence, investing in them could be riskier because of the greater attendant risk of failure.
How Market cap ranges are segmented
Companies with a market cap of over $200 billion are referred to as Mega Caps.
Those with a market cap between $10 billion and $200 billion are called Large Caps.
If the Market Cap is higher than $2 billion but lower than $10 billion, it is known as a Mid Cap.
Lower than $2 billion but higher than $300 million market caps are known as Small Caps.
A market cap higher than $50 million but lower than $300 million invites the description of Micro-Cap.
Analysis of popular investing segments
Large, Mid and Small caps are the segments most actively traded companies tend to fall into. What does investing in them mean?
Large Cap Stocks
This segment is likely to include the leaders in their respective fields, and some of the most widely known companies. They have proven themselves over a period of time, through economic cycles, and held off threats from competitors. They are likely to be generating more revenue than needed for running the business, with the result that many of them are likely to be regular dividend distributors.
Mid Cap Stocks
A market cap of $2 billion is no mean achievement and is the result of hard work and a business model that is becoming established. They have been able to move away from the fluctuations experienced by smaller caps and given some stability to their investors. But a long road still lies ahead. They probably compete with larger, better-funded competitors.
While there is headroom for growth in general, it is also possible that some of these companies operate in smaller niches and are already the leaders in it. These could also be larger caps that have slipped into this segment owing to marketplace disruptions and poor decisions.
Small Cap Stocks
These are likely to be growth stocks, of companies that have been successful in creating initial interest and are beginning to get established. Though they have a track record, as a group, of delivering above-average returns, their mortality and failure rate is higher than larger caps. Performance is also more volatile since huge waves in the ocean impact smaller ships more than the large ones. Many people invest in small caps as a diversification strategy, and over a long period of time, as risk mitigants.
The market cap should be used with care in an investment strategy
While it is a useful indicator of the company’s size and what it indicates to investors, like with any measure, it can only tell you so much.
While mega and large caps may seem too big to grow further, one can never say. In the huge global economy, a single mega-cap is still a small fry. Some of the tech stocks may have looked too big to grow or buy, several years back. But they have continued to deliver growth, performance, and returns.
Strong returns can be delivered even without growth in market cap; through share repurchase programs for instance that reduce the number of outstanding shares and leave remaining holders with a bigger share each of the company. Dividend payouts put money directly into the pockets of shareholders.
The same process, in reverse, could dilute shareholding. When a company needs money, to fuel growth or even to meet current requirements, it could resort to issuing fresh shares in return for money. This would make the holding of existing shareholders smaller in terms of the percentage ownership of the company. Dividends, as and when paid, will also be distributed out over a larger number of shares. This dilution risk is most likely to be associated with smaller caps.
Distributing your portfolio has been recommended to be a good strategy for investors. One of the ways in which to distribute is across market cap segments. By choosing stocks from different market cap segments, one can target desired returns and risk levels. Larger caps will provide greater stability, while smaller caps will provide headroom for portfolio growth. Allocate money to them in line with your desired goals.