What Does Market Cap Mean and Why Is it Important?

Stock traders often come across the word “Market Capitalization” or “Market Cap.” Stock exchanges, Nasdaq, S&P 500, Dow Jones also use this term often.  But what is a market cap?  Market Cap is the market value of the outstanding shares of a publicly-traded company. Market Capitalization reflects only the equity shares of a company and its value is calculated by multiplying the share price with the number of shares outstanding. Market capitalization acts as a robust determinant of a company’s net worth and in some cases, it also determines the valuation of some stocks. It allows investors to compare the relative size of a company with others. It measures the company’s worth in the open market and the market’s perception regarding the prospects of a company by reflecting on what the investors are willing to pay for the company’s stocks.

The investment community also prefers to use Market Capitalization to determine the value of a company. It uses Market Capitalization instead of total sales or assets to rank companies as per their sizes. It is also used to rank the relative size of various stock exchanges like Nasdaq or S&P 500.

Types of Companies Based on Market Capitalization

Traditionally stocks are divided into three segments based on market caps, namely Large, Mid, and Small Cap stocks. However, the terms Mega-cap, Micro Cap, and Nano Cap have also come into existence recently. Different indexes use different numbers to categorize enterprises based on their capitalization, and there are no exact cutoff values for categorization based on market capitalization. The cutoffs may be defined and instead represented in dollars because dollars need to be adjusted over the years due to changes in inflation, population, and overall market valuation.

Large Cap 

Stocks having a market value of 10 billion US dollars or more are termed as Large Capitalization stocks. These 10 billion US dollar worth share values generally represent large businesses that are major players in well-established industries. Large-capitalization stocks are known for producing high-quality goods and services and also for payments of consistent dividend payments to their shareholders. However, this is to be remembered that investing in Large Capitalization stocks does not guarantee the investors huge returns on their investments in the short run itself. But in the long run, the shareholders can expect steady growth in the dividend payouts.

Large Capitalisation stocks are often dominant players in the industry due to which the investments in Large-Capitalization firms are considered more conservative than investments in Small or Mid-Capitalization firms.

Mid Cap 

Stocks with a market capacity that ranges between $2 billion and $10 billion are termed as Mid-Cap stocks. Mid Caps are also established businesses operating in an industry that is soon expected to experience rapid growth.  These are the medium-sized enterprises that are in the process of increasing their market shares and improving their overall competitiveness.

Mid Cap stocks generally carry higher risks than Large Cap stocks because they are not still established as Large Cap stocks but are in the process of expanding. This stage of growth potential in the Mid Cap stocks determines whether they will eventually live up to their full growth potentials.

Mid Caps fall in between the Large Caps and the Small Caps in terms of associated inherent risks that the stocks have to bear. Mid-Caps offer more growth potential than large caps and carry less risk than Small Caps.

Small-Cap

Stocks having market capital within the range of $300 million shares value to $2 billion falls under Small Capitalisation stocks. Small Caps are generally new ones and are considered the highest risk investments in comparison to Large Caps and Medium Caps.  Also, the relatively limited resources of these companies make them more susceptible to economic downturns. Due to this, the prices of Small Capitalisation stocks tend to be more volatile and less liquid than larger companies. But on a positive note, Small Capitalisation stocks provide greater growth opportunities because of their ability to withstand volatile share price fluctuations in the short term as compared to Large and Medium Cap companies.

Micro-Cap Companies

Small companies within the range of $50 to $300 million shares value are known and Micro-Cap companies. Microcap stocks differ from other stocks since they are generally traded on stock exchanges that do not require minimum standards, like the minimum number of stockholders or minimum amount of net assets.

However small the sizes of these companies are, Micro Caps (and sometimes Nano Caps) are considered good for investments owing to their fewer available resources. These companies can make their information available to the public very quickly. Due to the small size of these companies, Micro and Nano Caps companies do not attract the attention of the stockbrokers much, and therefore these companies can focus on specializing in innovative products or services that may otherwise remain unknown to the public. Over time, Micro Capitalisation stocks have managed to outperform other stocks from Large and Medium Cap companies.

On the other hand, despite these advantages, Micro Cap and Nano Caps stock are susceptible to fraud and market manipulation due to their highly volatile nature, which increases the transaction costs of these stocks. Also, sometimes the Micro Capitalisation stocks are criticized for inefficient pricing because of the fewer institutional investors operating in this space, and as a result, the liquidity of these stocks is also limited.

Why Is Market Capitalization So Important?

Market Cap acts as a benchmark to calculate a company’s net worth, and therefore it is considered a very important assessment tool by the investment community. It is a basic parameter that is widely used in calculating important ratios like Market Cap to Sales. It is also used to compare similar companies and determine which is the most worth investing in. This is because the prices of stocks are affected by corporate actions like stock splits and bonus.

Here is why it is important to ascertain the Market Cap of stocks.

• It is otherwise very difficult to ascertain whether a company is worth investing in. But with the correct ascertainment of the companies’ stocks’ market caps, it becomes easier to estimate a company’s value by extrapolating the market’s behavior about the company’s public trading.
• Market capitalization helps in evaluating the company’s size, which yet again is a strong determinant of the extent of the risk factors associated with the company that the investors are willing to take up.
• Market Cap reflects the price that the investors are willing to pay for a company’s stocks. However, this price may not be the business’s true value; there are other underlying factors as well. If the Market Cap is considered the only metric to determine whether a company’s stocks should be invested in or not, only the price factor is taken into account instead of other available data.
• Market Cap data is often used to manage mutual funds. Companies holding these funds may allow investors to buy multiple stocks in a single transaction. As Mutual funds invest by category, it allows the investors to maintain a mixed portfolio of small-cap, mid-cap, and large-cap funds.

Factors Affecting Market Capitalization of Stocks

Over the years Large, Middle, and Small Caps companies have taken their terms in leading the stock market value as each of them responds to the economic developments in their respective ways; they are affected by several factors like fluctuations, dividend distribution by the companies, etc. As Market Capitalization is the product of the number of shares and their values, any change in stocks’ prices, up and down, can bring in significant changes in the Market Capitalization of stocks. It could also bring in changes in the number of shares issued by the company as if there are any warrants in the issuance of the company’s stocks, the number of outstanding shares will increase and consequently, it will dilute the existing value of the outstanding shares.

A stock split or dividend can also alter the Market Capitalization of the stocks. After a stock split, the number of outstanding stocks increases significantly reduces the stocks’ prices. The same thing happens when a company issues a dividend. The issue of dividends increases the number of shares held by the company, which reduces the stocks’ price.

Therefore, the companies must maintain a proper balance while issuing shares, and this can only be obtained by building a portfolio consisting of a proper mix of small-cap, mid-cap, and large-cap stocks. A diversified portfolio containing a variety of Market Caps helps the companies to reduce their investment risks and also in accomplishing long-term financial goals. To obtain a proper mix companies need to first evaluate their financial goals, time horizon, and risk tolerance levels.

FAQs

1. What Does the Market Cap Indicate?

Market Cap indicates the total value of the company’s stocks.  is the method of measuring the size of a company that categorizes companies into three main blocks- Large Cap, Middle, and Small Cap depending on the companies’ total value of shares. Market cap often provides a benchmark in assessing the company’s worth in the open market. It also reflects the market’s perception of its prospects, and the willingness of the investors to pay for its stock.

2. Is a High or Low Market Cap Good?

Market capitalization reflects a company’s stage in its business and economic development. Investments in Large-Cap companies are considered more conservative than in Small-Cap or Midcap companies. Mid Cap and Small Cap companies are more aggressive and, at the same time, more sensitive to economic downturns. But at the same time, Small Cap companies provide greater growth opportunities owing to their ability to withstand stock price fluctuations.  

3. Is the Market Cap the Value of a Company?

Yes, Market Cap represents the total value of a company in the open market. It reflects what the investors think about a company’s prospects and what value they are willing to pay for the company’s stocks. Market Cap reflects the company’s net worth, which is calculated by multiplying the number of outstanding shares of the company with the current market price.