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Understanding Market Capitalization

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Markets Capitalization

Market capitalization, also called MCAP or market cap, is a way to measure the size of a publicly-traded company.

It is computed by multiplying the current stock price and the number of outstanding shares. Meaning, a firm with one million shares trading at $5 a piece has a market capitalization of $5 million. You can buy that company for $5 million if you have enough funds and all the stockholders are willing to sell their shares.

Market capitalization also refers to the value of a stock exchange, and is measured by adding the market cap of all companies listed on that exchange.

One way of tracking market changes over a period of time is by using a market index, which is a basket of select stocks that is intended to reflect an entire market or a specific sector. Buying stocks under an index will also allow you to diversify your investments without having to spend much time and effort in trying to come up with a similar list of stocks.

Understanding Price-Weighted Index

In the price-weighted index, a stock’s share price is used as the basis in deciding its significance in the entire index. The higher the share price, the higher the weight assigned to that stock.  Any fluctuation in the share price will have more influence on the performance of the entire index compared to other components.

For example, an index is made up of two stocks: A, priced at $1, and B, priced at $10.

Because of the difference in share prices, Stock B will have a weight that is nine times higher than that of stock B. It means the index is made up of 90% stock B and only 10% of stock A and any fluctuation in the value of stock A will not have a significant effect on the value of the entire index.

You can compute the value of an index by adding the prices of every stock and dividing it by the total number of component stocks.

Common examples of a price-weighted index are the Dow Jones Industrial Average and Nikkei 225.

Understanding Capitalization-Weighted Index 

Another type of index is the capitalization-weighted index or the market value-weighted index. It is also a group of stocks, but they are weighed based on each company’s market capitalization.

You can compute this by adding the market capitalizations of all member stocks then dividing by an arbitrary number that will be determined later on, after the index is created.

For example, capitalization-weighted index ABCDE is made up of five listed firms.

Company A has a market cap of $50 million and 5 million outstanding shares.

Company B has market cap of $30 million with 1 million outstanding shares;

Company C has market cap of $20 million with 500,000 outstanding shares;

Company D has market cap of $25 million with 1 million outstanding shares; and

Company E has market cap of $100 million with 5 million outstanding shares.

To determine the percentage of each firm’s weight, divide every company’s market cap by the sum of all the components’ market cap.

Each member firm will then have the following weights:

Company A = 22.22%, or $50 million / $225 million;

Company B = 13.33%;

Company C = 8.9%;

Company D = 11.11%;

Company E = 44.44%.

A component with the highest market cap has the highest weight (in this case, company E), and any movement in its share price will have the greatest influence over the performance of the index.

In the example above, the divisor assigned to index ABCDE is 225,000. The index opens with a value of 1,000, computed by dividing the total market cap, or 225 million, by 225,000.

Classifying Stocks Based on Market Capitalization

A quick way to determine a company’s size is by looking at its classification based on market capitalization. Stocks are usually classified as large, mid, small, micro and nano cap.

Large cap stocks are the biggest companies on the stock exchange such as Apple (AAPL), Exxon Mobil (XOM), Google now known as Alphabets (GOOGL) and Microsoft (MSFT). While investment professionals have varying definitions, large-cap stocks are generally known as those with a market cap of more than $10 billion.

These companies are usually called blue chips and are seen to be the least risky investment because they have the financial muscle to survive a downturn. But because they are already market leaders, the industry thinks they have less room to grow compared to smaller companies, and may not have very high returns.

Still, large caps have a higher tendency to reward shareholders with dividends.

Mid Cap Stocks

Next are mid-cap stocks — a shortened term for middle capitalization — whose value usually ranges from $2 billion to $10 billion. They are considered less risky than smaller firms, but may also not have much room to grow. However, a study showed that they outperformed small and large cap stocks over the past 20 years.

Small Cap Stocks

Small-cap stocks generally have a market cap of $300 million to $2 billion. Most of these companies just conducted their maiden share sale or initial public offering (IPO). Since they are relatively smaller, the industry believes they are risky investments as they are more likely to default during tough times.

But on the positive side, small-cap stocks have great potential to grow and could become very profitable over the long term. Some mutual funds are also unable to give smaller firms a significant position in the fund because of restrictions in buying large portions of a company’s shares.

Therefore, buying shares of these companies gives you the opportunity to beat institutional investors.

Micro Cap Stocks

Micro-cap stocks are those with market cap between $50 million and $300 million. Companies under this category are often volatile, making them very risky investments. However, they are believed to have a huge potential to grow.

Nano Stocks

Some companies are also called nano stocks, or those whose market cap falls below $50 million. Because they are very small, these firms are perceived to have a high risk of failure and are called penny stocks. These are usually traded by new investors with a large appetite for risk.

Brokerages have different definitions of the large, mid, small, micro and nano cap stocks. The values presented above are just rough estimates and may change over time.

Knowing a company’s market capitalization will help you estimate the size of a company, and this is done by multiplying the share price with the number of outstanding shares. The biggest companies are called large caps, and the others range from mid, small, micro to nano cap stocks.

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