Market Capitalization: A Tool for Understanding a Stock’s Risk
Posted by Richard on November 13, 2013
Market cap — or market capitalization — allows investors to understand the relative size of one company versus another. Market cap measures what a company is worth on the open market as well as the market’s perception of its future prospects, because it reflects what investors are willing to pay for its stock. It is calculated by multiplying the price of a stock by its total number of outstanding shares. For example, a company with 50 million shares selling at $30 a share would have a market cap of $1.5 billion.
Large-cap companies are typically firms with a market value of $10 billion or more. They often have a reputation for producing quality goods and services, a history of consistent dividend payments, and steady growth. As a result, investments in large-cap stocks may be considered more conservative than investments in small-cap or midcap stocks, potentially posing less risk in exchange for less aggressive growth potential.
Midcap companies are typically businesses with a market value between $2 billion and $10 billion. These are typically established companies in industries experiencing or expected to experience rapid growth. These medium-sized companies may be in the process of increasing market share and improving overall competitiveness. Midcaps may offer more growth potential than large caps, and possibly less risk than small caps.
Small-cap companies are typically those with a market value of $300 million to $2 billion. These are generally young companies that serve niche markets or emerging industries. Small caps are considered more aggressive and risky. The relatively limited resources of small companies can potentially make them more susceptible to a business or economic downturn. They may also be vulnerable to the intense competition and uncertainties characteristic of untried, burgeoning markets.
Micro-cap companies have a market capitalization of between $50 million to $300 million. The upward potential of these companies is similar to the downside potential, so they do not offer the safest investment, and a great deal of research should be done before entering into such a position.
What Impacts a Company’s Market Cap?
There are several factors that could impact a company’s market cap. Significant changes in the value of the shares — either up or down — could impact it, as could changes in the number of shares issued. Any exercise of warrants on a company’s stock will increase the number of outstanding shares, thereby diluting its existing value. As the exercise of the warrants is typically done below the market price of the shares, it could potentially impact its market cap.
But market cap typically is not altered as the result of a stock split or a dividend. After a split, the stock price will be reduced since the number of shares outstanding has increased. For example, in a 2-for-1 split, the share price will be halved. Although the number of outstanding shares and the stock price change, a company’s market cap remains constant. The same applies for a dividend. If a company issues a dividend, its price usually drops as the number of shares increases.
To build a portfolio with a proper mix of stocks, you’ll need to evaluate your financial goals, risk tolerance, and time horizon. A diversified portfolio that contains a variety of market caps may help reduce investment risk in any one area and support the pursuit of your long-term financial goals.1
1Diversification does not assure a profit or protect against a loss.
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