One of the lessons many of us learn is that the investment you make in an item is frequently not the same as its value. Think back to when you were a child and you saved and saved for some item that your parents thought was silly, but it held some value to you. Teenagers, as a rule, love brand names and the perceived status they provide, but when they start spending their own hard-earned dollars they begin to understand that the value of an item is not based solely on price.
Unfortunately, although many of us learn this lesson when it comes to our personal finances, we tend to forget about it when it applies to investing.
For example, if you could invest in a company with shares that cost $40, or in a company that has a share price of $80, which company is more valuable? The novice investor might say the company that’s valued at $80. However, if you understand the concept of market capitalization your answer is probably, "I don't have enough information" and you would be right. When determining the value of a company or an individual stock, the price is not the only consideration.
Which brings us to the topic of this article. When investors are looking to choose the value of a stock, there are many metrics to consider. One of the metrics is the market capitalization (or market cap). This article will define what market capitalization is, what it means to you as an investor, what can make a company’s market capitalization increase or decrease, the classifications of market cap stocks, and how you can invest based on market capitalization.
What is market capitalization?
To determine a company’s market capitalization (or market cap), you will multiply the current price of a single share by the number of total shares outstanding (i.e. the number of shares available to be publicly traded). So if a company has 10,000,000 outstanding shares and is currently selling at $50 per share, its market cap would be $500 million dollars. In many cases, a company’s market cap is easily found without having to do the calculation.
What does market capitalization mean to investors?
Market capitalization is one measurement that investors can use to assess the value of a company in the stock market. Many inexperienced investors presume that the value of one company compared to another is evident in their price per share. However, a simple example will help show why that is not true.
Company A = has 1,000,000 outstanding shares that sell at $100 per share. Their market cap will be $100 million dollars.
Company B = has 10,000,000 outstanding shares that sell at $80 per share. Their market cap will be $800 million dollars.
Obviously, company B is the much larger of the two companies, even though company A’s stock costs more per share.
However, the market cap is only a direct measurement of the financial size of a company. The value of a company includes many other factors, some of which are intangible and can mean something very different to individual investors. This is an important distinction. Because while a company may have significant value in the stock market, that doesn’t necessarily mean it should be in your portfolio.
We see the relationship between price and value all the time in professional sports. Generally speaking, a player perceives his value by the amount of money a team is willing to pay them. The team has to look at what that player, no matter how good they are, is worth to them. In most cases, it’s the market that’s setting the price of the contract, but it’s up to the team management to decide if the value of that player to the team outweighs the risk of the expensive contract.
It’s the same in investing; the market sets the price of a stock, which in turn affects a company’s market cap. It’s up to individual investors to decide whether the value of owning that stock is worth the risk. Each category of stocks carries its own risk-reward scenario.
What can make a company’s market capitalization increase?
Since market capitalization is based on the volume of outstanding shares and the price per share, a change in either one will cause a market cap to rise or drop. The most obvious way a company’s market capitalization can increase is to increase their stock’s value (i.e. for their price per share to rise). This essentially means a company meets or exceeds performance expectations and is rewarded by having investors want to buy shares of their company, which in turn drives up the price of each share.
A second way is for a company to issue more shares. This is typically done because the company is looking to raise capital. At first, investors may see a slight dilution in share price as more shares are put on the market, but the market cap would still increase unless the share price took a big hit for another reason.
What can make a company’s market capitalization decrease?
Using the same two variables of price per share and volume of outstanding shares, let’s look at how a company’s market cap could decrease.
First, their shares lose value. This essentially means the company did not meet performance expectations which may cause investors to sell, which in turn drives the price per share down. While no investor likes to see the price of a share decrease, many investors know that this is a normal part of investing and can use these dips to add more shares which can increase the value of their portfolio should the market rebound.
But how can the number of outstanding shares drop? Occasionally a company may engage in the practice of buying back some of their outstanding shares in an effort to improve shareholder value or to improve earnings per share (EPS) ratios. This will make a company’s market cap go down as this example shows:
A company has 1,000,000 outstanding shares valued at $50 per share. They have a market cap of $50 million dollars. They buy back 100,000 shares. Their new market cap is:
900,000 x $50 = $45 million
In reality, the amount that the market cap drops may be less because a company is buying back shares in anticipation of their stock price going up. And even if the stock price doesn’t increase for performance reasons, it should go up simply because each shareholder’s relative ownership stake will increase because there will be fewer claims, or shares, on the earnings of the company.
What are the categories of market capitalization?
There are three broad categories of market caps: large cap, mid cap, and small cap. In general, a company is said to have a large market cap if it has a market capitalization of over $10 billion. Mid-cap companies have a market cap between $2 and $10 billion and small-cap companies have a market cap of less than $2 billion. There are other designations like micro caps (beneath small caps) or ultra caps (above large caps), but for the purposes of this article, we'll stick with these three categories.
As stated above, these are companies that have a market capitalization of over $10 billion dollars (think companies like McDonald's or Apple). These are mature, well-known companies that will have more assets, capital and generate larger revenue than smaller companies. In general, large-cap companies are considered more conservative than smaller companies. This simply means they typically do not offer the chance for aggressive double-digit growth that smaller companies will. However, these companies will generally offer dividends to their investors and can generally be seen as the bedrock of a portfolio because they can be expected to increase in value over time. And because these stocks are not typically subject to the volatility that can affect the stocks of smaller companies, large-cap companies are also typically some of the better stocks to own during a market downturn.
Mid-cap companies are established within an industry or sector and are positioned for potentially rapid growth. They have a market cap between $2 billion and $10 billion dollars. Mid-cap companies are considered to be in the middle of their growth curve. This makes them less risky investments than small-cap stocks, but riskier than large caps. Mid-caps are usually more focused on one specific sector and are probably seen as a solid niche player within their target market. As an investor, you may like the balance of growth and stability that mid caps offer. When the economy is expanding, mid-cap stocks benefit from low-interest rates and inexpensive capital costs. They can also get the credit they need to continue on their growth curve. When the economy slows down, mid caps are typically still well-positioned to ride out the storm.
These stocks have a relatively low market cap (less than $2 billion). Analysts won't debate that small-cap stocks have outperformed large-cap stocks over time. However, that requires investors to have the patience to hold onto these stocks during times of volatility. Because that's what you're likely to get with these stocks. They offer greater room for aggressive growth, but with that opportunity for reward comes a high level of risk. Small cap stocks were praised as the tech bubble burst and investors fled some of the large-cap companies that had lost value after the crash.
How do you invest based on market cap?
As we mentioned before, the market cap is only one metric that an investor will use in their fundamental or technical analysis of a company. And when you get right down to it, it really only tells you for certain the size of the company. From there, you can begin to make some assumptions about the growth potential and potential volatility of a given stock.
In general, investors should own all three types of stocks. This is because, at any given moment, one or more of these categories may outperform another. By diversifying your portfolio to include all types, you can find the right mix of growth and stability that you want.
You can buy shares of stock in individual companies. To do this you need a way to measure one company's returns against similar companies. For large-cap stocks, the S&P 500 is an index that you can use to measure one stock against another. For mid-caps, the S&P MidCap 400 is a useful index and for small-cap stocks, you can use the S&P SmallCap 60 or Russell 2,000 indices.
To further help you diversify, many mutual fund companies cater to investors by having funds that specifically invest in stocks with the same market capitalization. Many mutual fund investors like the idea of knowing they have diversification without having to take the time to research the stocks themselves. As with selecting individual stocks, you’ll want to make sure that you divide your investment among different-sized companies.
The bottom line on market capitalization
Market capitalization is considered one of the fundamental metrics for investors. It lets you know what size company you are looking at, which then helps you understand what kind of growth and volatility you can expect by owning that stock.
What market capitalization is not is a true measurement of a company’s value. To determine that you have to consider things like your investment objectives, the time frame you have to invest and your own tolerance for risk.