By: Rupesh Oli
What is Market Capitalization?
Market Capitalization, or market cap, refers to the aggregate valuation of the company/stock based on its current share price and the total number of outstanding shares. It is amongst those significant financial metrics that help the investor evaluate the risk and return associated with the stock on one hand and on the other hand, aid investors in selecting the right stocks in the portfolio in accordance with the risk and diversification criteria that one wants to align with. It, further, helps investors rank the companies and compare the relative sizes in a particular industry.
Market cap also refers to the total value of the stock exchange. For instance, the market cap of NEPSE (Nepal Stock Exchange) equals the total market cap of all the companies trading on NEPSE combined—the aggregate of banking, hydropower, microfinance, finance, life insurance, mutual fund, and the remaining seven sectors trading on NEPSE.
How to Calculate Market Capitalization?
Market Capitalization is calculated by multiplying the stock price of the company by its total number of shares outstanding. For instance—let’s say—the company’s total number of outstanding shares is 10 crores and trading at Rs 200 per stock. Hence, the company’s total market capitalization would be Rs 20 billion in total.
Market Capitalization Categories
Micro-cap stock refers to relatively young companies in the stock market. They are the ones that require in-depth research before performing any sort of investment, particularly their fundamentals to gauge whether they can be considered a safe investment or not. In addition, they have the tendency to either grow exponentially or decline in the coming days for which the study of the fundaments is a must for investment.
These are the stocks with a market capitalization ranging from $250-300 million to $1-2 billion (in global context). They are the companies generally in the growth stage depicting high emphasis on both the risk and the return they could provide.
Mid-Cap stocks possess a market capitalization that ranges from $2 billion to $10 billion. They are considered to be less risky—if compared to the small-cap stocks. However, in terms of volatility, they surpass large-cap stocks. This category is inclusive of the stocks that are experiencing growth in the industry or are expected to do so. Further, they might be in the process of increasing the market share and differentiating themselves to stay peculiar from the herd in order to diminish its competitiveness to an extent. Generally, signifying the established companies with the growth potential, these stocks might turn out to be the ones leveraging the investors over the haul considering the growth potential.
Those who are less inclined towards investing and the stock market also might have come up through the list of large-cap stocks—if not the well-reputed companies like Apple, Amazon, Microsoft, and Facebook. These are the stocks with a market capitalization of over $10 billion—that’s why—referred to as large-cap stocks. They are the ones with the highest reputation in the stock market be it from any industry. They reflect the consistency in their product quality, services, innovation, and financial strength; however, depict the steady growth. Often, they are the ones considered to be the safest investment among the four.
Related: Small-Cap Stocks Vs Large-Cap Stocks
Factors Impacting a Company’s Market Capitalization
There are various factors impacting a company’s market capitalization. Unlike the financial indicators such as net profit, liabilities, and assets shown in the financial reports of the company, the market capitalization won’t remain the same for the quarter. Instead, market capitalization fluctuates on a daily basis. It’s because the stock price for that particular company fluctuates too. It is therefore imperative that an investor ought to perceive the factors that impact the market capitalization of a particular stock.
Factors such as issuing of new shares, buying back of shares, market fluctuations—as stated above, the performance of the company, surge in the competition from the competitors, change in demand of produce or service of the company, status of reputation and reliability of the company can be considered as some of the many factors impacting a company’s market capitalization.
Significance of Market Capitalization in Analyzing Stocks
Investors ought to comprehend that market capitalization used solely won’t reveal the actual potential of the stocks. It must be used alongside the other indicators such as EPS, P/E ratio, net worth per share, Return on Equity, and so on. Nevertheless, its significance must not be overlooked. When an investor is aware enough of the market capitalization, they can split up their investment based on the potential risk and reward that each stock on varied market cap category offers. Ultimately, it leads an investor to have a balanced portfolio comprising a mix of different market caps that would otherwise have been deviated towards a particular category—might be leading towards a high risky investment approach no matter what the return would have been expected over the haul.
For instance—let’s say—rather than opting for stocks randomly, an investor opted to select stocks from different market cap categories—the small-cap, medium-cap, and large-cap. Suppose, the portfolio now gets affected due to an economic downturn or unavoidable market fluctuations. In such a scenario, the diversification based on market cap comes into play as it safeguards the investor by reducing the investment risk as small- and mid-cap stocks might be declining on the one hand, whereas the large-cap stocks might be surging up on the other hand. As a result, portfolio balance based on market cap comes in handy.
In addition, the market cap provides an investor insight into how a particular stock trade. The larger the market cap of a stock, the more reasonable will be the bid-ask spread ultimately leading to the surge in the possibility of the particular stock acting as a highly liquid stock in comparison to the one with a lower market cap. To make an effective comparison amongst the sectors or within the same sector—between the two companies—market capitalization is imperative. Market capitalization is a significant tool for analysis in various roles such as financial analyst, accountant, investment analyst, and trade analyst as they use it frequently.
Market Cap: Risk and Reward
In a financial world, the majority of us have the say that the more risk we take, the more reward we are liable towards. In accordance, the risk and reward can be weighed on the particular stocks based on their market capitalization. Generally, the large-cap stocks are considered less risky in comparison to the small- and mid-cap stocks. In addition, the mid-cap stocks fall between the large- and small-cap stocks in terms of risk and reward potential.
There are various factors that determine the risk and reward associated with the stocks that fall under respective market cap categories. For instance, the volatility, growth potential, resources availability of the company, and so forth. The small-cap companies might be lacking in terms of resources relative to the other firms in the same domain leading them to become more susceptible to the business or economic downturn along with the elevated vulnerability to the prevailing intense competition. So, they are more volatile in nature. However, they are the ones with significant growth potential delivering the exponential return if the company can stand up to the mark in the coming days that would be gauged based on their performance.
On the other hand, large-cap stocks are considered to be safer considering them to be the less risky cap among the four. However, it depicts the steady growth and low volatility due to which an investor has to compromise on the reward/return compared to the mid- and small-cap stocks.
Ultimately, it all boils down to the nature of investors whether they can tolerate the risk, or the volatility associated with each of the market cap categories, and the return they garner is based on what they reflect.
2022 Largest Companies by Market Capitalization
As of March 31, 2022, below is the list of the 20 largest companies by market capitalization across the globe.
|Johnson & Johnson
|Procter & Gamble
What does Free Float Market Capitalization Signify?
Free Float Market Capitalization differs from the market capitalization. The free-float market capitalization excludes the shares held by the government and the company executives—only considers the outstanding shares available to the general public for trading. It’s because not all the shares trade on the open market. Nevertheless, indices such as S&P 500, Dow Jones Industrial Average or NEPSe take into consideration the free-float methodology when they come up with the valuation of market capitalization.
Market Capitalization Limitations
It is obvious that every financial indicator possesses some limitations or drawbacks alongside its pros. Market capitalization helps investors identify the stocks that fall under different market cap categories allowing the room for diversification based on it, however, its limitations—listed below—is something that cannot be left unnoticed.
- It does not take into account the company’s debt and other financial liabilities.
- Financial indicators such as dividends and split-offs are not considered in the market capitalization figure of a stock.
- Market capitalization won’t be effective when it comes to evaluating a company in case of a merger or acquisition.
The Final Takeaway
Robert R. Johnson—Professor of Finance at Creighton—mentions that small-cap stocks tend to perform better than mid- and large-cap stocks notwithstanding the fact that they are more volatile in nature. He further adds that small-cap stocks provided an annual return of 11.9% from 1926 to 2019 compared to the 10.2% annual average return of large-cap stocks. The difference between the two might seem trivial, however, the difference is enormous over the haul. If we consider the $1 invested in small-caps at the end of 1925, the amount would have grown to $39,380.90 and for the large-cap stocks, it would have grown to a mere $9,243.90—Johnson mentions. Hence, the final takeaway is that small-cap stocks might deliver high returns over the haul but come at the cost of higher risk too. On the other hand, the mid- and large-cap stocks might provide you with low returns; the risk is minimal too.
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