When making investment decisions, you'll want to build a portfolio that fits your financial goals, but one that is also in line with your personality and habits - such as your willingness to take risks, the time you can dedicate to managing your investments, and the level of information you have about the market. To pick the right stocks for such a portfolio, one of the first things you'll want to look at is market cap. Based on a simple formula, it is one of those basic tools that can help you tell apart steady but often slow stocks from more volatile and riskier but also perhaps more exciting investment targets.
What is market cap for stocks?
Market capitalization, or market cap for short, is an important metric for comparing the size of listed companies. It is very easy to calculate: simply take the total number of shares a company has outstanding, and multiply it with the current market price of one share. To show a simple example: the market cap of a company with 20 million shares outstanding whose last market price was $50 is $1 billion. Once you have this number, you’ll be able to judge the size of a company quickly and compare it with other listed companies. You don't necessarily have to do this calculation by hand, as you can usually find market cap information on financial websites and in the research section of your broker.
Keep in mind that the share price used to determine market cap is the price of the last transaction only, which might have been for just 100 shares. So, for example, it cannot really be used to gauge how much the company would be worth if it was to be taken over by another company.
In addition to individual stocks, you can also determine the total market capitalization of an entire market. For example, the market cap of the Tokyo Stock Exchange is the sum of the market caps of all listed Japanese companies. At the time of writing, it stood just below $6 trillion.
How does market cap change over time?
Since market cap is the product of a multiplication, if one of the components changes, so does the market cap. Usually it’s the share price that moves market cap, as the number of shares issued doesn’t change frequently. If the share price increases by 5%, market cap likewise goes up by 5%.
A company's market cap is first established via an initial public offering (IPO) of shares. Over time, the company may issue additional shares. However, market cap might not go up automatically just because the number of shares has increased. This is because new shares often have a dilutive effect for existing shareholders; as the intrinsic value of the company (such as its ability to generate profits or dividends) is distributed among a larger number of shares, it diminishes the value and attractiveness of each share, and therefore the share price.
By the same token, investors usually welcome share buybacks, as it increases the relative value of each share, which will be reflected in a higher share price - often leaving market cap unaffected despite fewer shares outstanding.
Small cap vs large cap companies
To be able to better understand the concept of market cap and how it is used to differentiate among listed companies, you should take note of the three main categories of market cap: small, mid and large caps. (Some categorizations also include micro and mega caps.)
1) Small cap companies are those with a market cap between $300 million and $2 billion; a random example would be IT company Unisys Corp. with a market cap of $816 million as of 30 October, 2020. Small caps are more sensitive to changes in the state of the overall economy compared with bigger cap entities, mainly because of their younger age and small size. Penny stocks are also much more volatile and riskier, though not every small cap company is a penny stock. You can read more about penny stocks here.
2) A large cap company is one with a market cap greater than $10 billion, e.g. MasterCard with $292 billion as of this writing. Large caps are usually more predictable and steady, as over time they have reached a size that leaves them less vulnerable to economic cycles.
3) Mid caps are somewhere in between, defined as having a total market cap of $2-10 billion. For example, Harley Davidson or Cameco fit this category.
You’ll find that this categorization is widely used by funds and ETFs, e.g. a large-cap equity fund may have a certain mandate as to what kinds of stocks it is allowed to buy.
Source: Visual Capitalist
The pros/cons of trading in small vs large caps
Small caps are usually more sensitive to business cycles and changes. Because of that, and the fact they are usually held by fewer investors, price action is more volatile in these names. They are also more likely to go bankrupt than bigger companies. Fraud involving small caps or micro caps is also more likely, though this mostly involves companies that aren't listed on any stock exchange. In any case, caveat emptor!
At the same time, one unique value of small caps is their growth potential. Another plus for small caps is that they're not as much in the spotlight as large or mega caps, meaning that smaller investors have a greater chance of discovering and buying these stocks on the cheap, before big institutional investors find them and push the price up, should the company turn out to be a success. In another positive, volatility works both ways: you’ll find no bid is too low if there’s a big seller of a small cap stock, and no ask is too high if there’s a willing buyer who wants to buy a big chunk of shares. Another chance to profit from small-cap stocks is when a small-cap is company acquired by a larger company, which usually happens at a premium.
Investing in a large cap company also has its benefits and disadvantages. Large cap stocks are for you if you prefer lower risk and long-term investments, because they can be pretty steady earners over time. This is especially true for blue-chip companies. A large cap company is also more likely to pay dividends, which might be important for those investors looking for steady income in addition to share price gains. What also matters, especially if you are an inexperienced investor, is the amount of accessible information about the enterprise. The larger a company is, the easier it is to find reliable research, as these companies are followed by many Wall Street analysts.
On the other hand, a large cap stock is less likely to multiply its price over a short period, and the absence of volatility also means fewer opportunities for quick and easy price gains.
So what should you consider when creating your investment portfolio? Most experts would argue that it’s best to create a diverse portfolio, because large, mid and small cap stocks tend to react differently to market changes, therefore it’s safer to have a mix of all these categories.
|Small caps||Large caps|
|Main advantage||Higher growth potential||More stable, might pay dividend|
|Research||Less available information; might not be followed by any analyst||Information widely available, followed by many analysts|
|Price volatility||Usually higher||Usually lower|
|Liquidity||Usually lower||Usually higher|
What is market cap for cryptocurrencies?
If you were wondering what the difference is between market cap for shares versus market cap for cryptocurrencies, let us explain. In this content, market cap shows the relative size and popularity of a cryptocurrency. The formula is also a multiplication of two factors, one being the current market price of a cryptocurrency and the other being the total number of circulating coins.
For example, if each unit of the imaginary BrokerChooser coin is being traded at $10 and the circulating supply is 25,000,000 coins, the market capitalization for this cryptocurrency would be $250,000,000. The result also shows the dominance of a particular cryptocurrency: the higher this value, the more dominant the coin is on the market.
Market cap for cryptocurrencies is usually used in the context of the “Bitcoin Dominance Index”, which refers to Bitcoin’s (BTC) market cap compared with the aggregate market cap of all the other cryptocurrencies.
Investing in larger-cap and established cryptocurrencies may be safer compared with smaller-cap, up-and-coming-coins, because the former are thought to be less volatile and more stable.
How do you calculate market cap?
Multiply the total number of the outstanding shares of a company with the current price of one share.
Where do I find the market cap of a stock?
You can usually find the market cap of a stock on financial websites and in the research section of your broker.
How is it possible that the shares outstanding in a company increase or decrease?
Warrants, employee stock options, at-the-market (ATM) offerings or secondary offerings are all possible means of issuing additional stock, diluting the shares of existing shareholders.
Conversely, the number of outstanding shares is reduced in the case of a share repurchase (also called a share buyback), when a company buys back its own shares.
Which companies have the highest market cap?
Just to mention a few: Apple, Microsoft, Amazon, Alphabet (the parent company of Google) and Alibaba.
Does market cap change every day?
Yes, as the share price is moving. However, transition from, say, mid- to large-cap status usually takes quite a lot of time.
Why do small cap stocks have higher volatility compared with large cap stocks?
Because small cap companies are usually more exposed to changes in their industry or the state of the economy because of their (often young) age and small size; while the performance of large-cap enterprises is usually more stable even in adverse circumstances. Also, large caps are followed by many investors, so usually there will be many bids and asks at marginally lower and higher prices compared with the spot price; this helps to prevent steep price movements.
Why is it that stock splits don’t affect market capitalization?
Because when doing a stock split, companies simply divide their stocks into several pieces, and the value of these new shares will drop proportionately, so e.g. instead of one share worth $100, you will have ten shares worth $10 each. As a result, the shareholder won’t be affected either negatively or positively, and everything remains the same in terms of the total value of outstanding shares. For the same reason, market cap is not affected by reverse stock splits either.