If you’re researching stocks or stock funds, you’ll often see companies categorized by market capitalization. but what is this and why does it matter?
Market capitalization, or market capitalization, is a measure of the size of a company. is the total value of a company’s outstanding shares, which includes publicly traded shares plus restricted shares held by officers and insiders of the company.
Reading: What is the market cap of a stock
To calculate market capitalization, you take the total number of outstanding shares of a company and multiply that number 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.
You may hear companies described as large-cap, mid-cap, or small-cap, or even mega-cap or micro-cap. the delineation between each group may vary, but in general, you’ll see them broken down like this:
- mega cap: market value of $200 billion or more;
- large cap: market value between $10 billion and $200 billion;
- mid cap : market value between $2 billion and $10 billion;
- small cap: market value between $250 million and $2 billion; and
- micro cap: market value of less than $250 million.
Certain stock indices or mutual funds will use this measure to group companies by size. For example, the S&P 500 is made up of mega-cap and large-cap stocks and is weighted by market cap, so companies with a higher market cap account for relatively more of the index than companies with a comparatively high market cap. minor. meanwhile, the russell 2000 index is a small-cap stock index.
Newer investors may mistakenly believe that share price alone could be a good indicator of a company’s size, but the most important thing in determining a company’s size is the number of shares outstanding.
Take Company A and Company B, for example. They both have shares trading at $50 a share, but Company A has 5 million shares outstanding and Company B has 5 billion shares outstanding. that means company a has a market cap of $250 million, making it a small cap company, while company b has a market cap of $250 billion, making it a small cap company. a particularly large large-cap company, often called a mega-cap company.
why market capitalization matters
For starters, market capitalization can give you a general idea of where a company stands in the business development process. Is it a relatively new public company, for example? if so, you could have room for growth. after all, access to investor capital to expand the business is the reason many companies decide to go public in the first place.
Market capitalization can also provide a rough indicator of a company’s stability. Large-cap companies tend to be less vulnerable to market ups and downs than mid-caps, and mid-caps are generally less susceptible to volatility than small-caps.
That’s in part because larger companies tend to have larger financial reserves and therefore can often absorb losses more easily and recover more quickly from a bad year. at the same time, smaller companies may have greater potential for rapid growth in good economic times than larger companies. this is why some dividend seekers will use market capitalization as a filter when looking for companies that pay consistent dividends.
These generalizations are no guarantee that any particular large-cap company will weather a recession well or that any particular small-cap company will or will not prosper. Still, market capitalization can be a useful indicator, especially when it comes to diversifying your portfolio. When you diversify, your goal is to manage your risk by spreading your investments. you can diversify by investing across different asset classes; for example, by investing in both stocks and bonds. and you can also diversify within asset classes. Investing in large and small cap stocks is an example of diversification within an asset class (stocks).
the limitations of market capitalization
An important thing to keep in mind is that market capitalization is the perceived value of a company because the price of the stock is determined by investors. it is not necessarily the real value of a company and all its parts. Some of that perceived value may come from expectations of future growth or a product introduction, but those expectations may not be met, in which case the company’s stock price, and thus its market cap, adjust accordingly.
That’s why it’s a good idea to consider a number of metrics when considering an investment. Market capitalization can be a tool you use to build a diverse portfolio, but it shouldn’t be your only tool.