If you are researching stocks or stock funds, you'll often see companies categorized by market capitalization. But what is it and why does it matter? Read on to learn more.
Market capitalization, or market cap, is one measurement of a company's size. It is the total value of a company's outstanding shares of stock, which include publicly traded shares plus restricted shares held by company officers and insiders.
To calculate market cap, you take the total number of a company's shares outstanding and multiply that figure by the company's current stock price. For example, if a company has 5 million shares outstanding and its current stock price is $20, it has a market capitalization of $100 million.
But here's the catch: because stock price is determined by investors, market cap is the perceived value of a company. It isn't the actual value of a company and all of its parts.
You may hear companies described as large-cap, mid-cap or small-cap. The delineation between each group can vary, but generally, you'll see them broken down like this:
- Large-cap: Market value of $10 billion or more;
- Mid-cap: Market value between $2 billion and $10 billion;
- Small-cap: Market value between $250 million and $2 billion;
- Micro-cap: Market value of less than $250 million.
Certain stock indexes or investment funds will use this measure to group companies together by size. For example, the S&P 500 is made up of large-cap stocks and is weighed by market cap, so companies with a higher market cap account for relatively more of the index than companies with a comparatively smaller market cap. Meanwhile, the Russell 2000 Index is a small-cap stock market index.
Newer investors might mistakenly believe that stock price alone could be a good indicator of how large a company is, but what is most important in determining a company's size is the number of shares outstanding.
Take Company A and Company B, for example. Both have stocks trading at $50 a share, but Company A has 5 million shares outstanding, and Company B has 5 billion shares outstanding. That would mean Company A has a market cap of $250 million, making it a small-cap company, whereas Company B has a market cap of $250 billion, meaning it's a particularly large, large-cap company.
Why Market Cap Matters
For starters, market cap can give you a general idea of where a company stands in the business development process. Is it a relatively new public company? If so, it might have room for growth. After all, access to investor capital to expand the business is why many companies decide to go public in the first place.
Market cap can also provide a rough gauge of a company's stability. Large-cap companies tend to be less vulnerable to the ups and downs of the market than mid-cap companies, and mid-cap companies are generally less susceptible to volatility than small-cap companies.
That's in part because larger companies typically have greater financial reserves and can therefore absorb losses more easily and bounce back more quickly from a bad year. At the same time, smaller companies may have greater potential for fast growth in economic boom times than larger companies. This is why some dividend seekers will use market cap as a filter when looking for companies that pay consistent dividends.
Even so, these generalizations are no guarantee that any particular large-cap company will weather a downturn well or that any particular small-cap company will or won't thrive.
In fact, it's worth noting that even the largest companies can fail. Take WorldCom, for instance. In 1999, the telecommunications business reached a peak market cap of about $186 billion dollars. But by July 2002, it had filed for Chapter 11 bankruptcy protection—the biggest bankruptcy filing ever at the time—and its stock dropped to $0.
Still, market cap can be a useful gauge—particularly when it comes to diversifying your portfolio. When you diversify, you aim to manage your risk by spreading out your investments. You can diversify by investing among different asset classes; for example, by investing in both stocks and bonds. And you can also diversify within asset classes. Investing in small-cap and large-cap stocks would be one example of diversifying within one asset class (stocks).
The Limitations of Market Cap
But here's something important to keep in mind: because stock price is determined by investors, market cap is the perceived value of a company. It isn't necessarily the actual value of a company and all of its parts. Some of that perceived value may stem from expectations of future growth or the introduction of a product, but those expectations may not pan out, in which case the share price of the company—and thus it's market cap—is likely to adjust accordingly.
That's why it is a good idea to look at a number of metrics when considering an investment. Market cap can be one tool you use to develop a diverse portfolio, but it shouldn't be your only tool.
Want to learn how you can evaluate a public company's financial performance? Here are six terms to know.