How to Potentially Capitalize on Market Cap

October 19, 20226 min read
How to Potentially Capitalize on Market Cap
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Key Takeaways

• The total value of a company’s outstanding shares, market capitalization is a measure of a company’s worth as defined by the stock market.

• Also used to determine a company’s size, market cap provides a means of comparison of its financial performance in relation to other businesses.

• Generally, companies with larger market caps are considered more stable investments because they usually have longer track records than companies with smaller market caps.

The term market capitalization (or market cap) is an expression of the total market value of the outstanding shares of stock in a company. Market cap also serves as a measure of the size of a company, as opposed to calculating its sales or the value of all of its assets. One common use of the market cap for mergers and acquisition firms is to determine a company’s suitability for takeover. 

Ultimately, a company’s market cap is the measure of a company’s worth as defined by the stock market. However, it is not a measure of the true value of a business. Market cap reflects only what investors would pay to own shares of a company. To find the true value of a company — its enterprise value — one must subtract the total amount of a company’s operating liabilities from the total value of its assets.

Which raises the question, how does one calculate market capitalization?

Calculating Market Cap

Multiplying a company’s most recent closing share price by the total number of its shares outstanding returns its market cap. 

As an example, consider a firm with 40 million outstanding shares selling at $200 per share. This would render a market cap of $8 billion. In contrast, consider another company with a share price of $200 and 50 million outstanding shares. This company would have a market cap of $10 billion, despite having an identical share price, because it has more shares in circulation. 

The first time a company’s market cap is established is the initial public offering of its stock. Firms typically consult with investment banks to determine the company’s value in order to arrive at the number of shares to offer and at what price. 

In a situation in which the value of a company is established to be $200 million, the bank could issue 10 million shares at $20 each or 20 million shares at $10 each. Either way, the market cap is initially set at $200 million. 

The market subsequently determines the market cap with its trading activity. 

The Importance of Market Capitalization

A tool by which investors can determine the value of a company as perceived by the public, a company’s market cap can be an indicator of the degree of risk an investment in that company would entail. The market cap can also serve as an indicator of the potential return an investment in that company would generate. 

Generally, the higher the perceived market cap value, the larger the company is considered to be. Thus, public companies are typically grouped according to market caps. A mega-cap company is valued at $200 billion-plus, a large-cap company is valued between $200 billion and $10 billion, a medium-cap company is valued between $2 billion and $10 billion, a small-cap company is valued between $2 billion and $250 million, while a micro-cap company is valued at less than $250 million.

Market Caps and Investment Strategies

Mega-cap and large-cap companies tend to be mature. Having experienced most of their growth, they are usually more stable, often have diverse revenue streams and can potentially deliver consistent dividend payouts. These stocks also tend to experience only minor deflections in share price in sympathy with market fluctuations. This can make them an attractive investment for investors seeking stability. The S&P 500, made up of mega-cap and large-cap stocks, shows an annualized 10-year return of 9.63% between 2012 and 2022.

Medium-cap companies are usually younger and in the middle of their growth phase. This can make them useful for investors seeking higher returns at a faster rate. However, with that potential comes the possibility of significant downturns, as these companies often directly reflect the fluctuations of the market in general. The S&P MidCap 400 annualized return was 8.20% between 2012 and 2022.

Small-cap companies are typically young, small, and poised for outstanding growth. However, they are also among the riskiest investments. Their revenue streams usually show minimal diversification and are heavily dependent on economic growth as a whole. Tax and regulation changes can also have a magnified effect on these companies. Speaking in general, when the economy catches a cold, small-cap companies often contract the flu. 

The S&P SmallCap 600 annualized return was 8.21% between 2012 and 2022, demonstrating that small-cap stocks do represent the potential for growth. However, experts agree that including them in a portfolio is usually only wise when balanced by more stable large-cap holdings.

Micro-cap companies are among the riskiest investments of all. Many of them typically have no track record of which to speak, and some may not even have assets or revenue. With that said, the Dow Jones Select Micro-Cap Index shows an annualized return of 9.41% between 2012 and 2022. Despite this result, just as with small-cap stocks, including them in a portfolio is usually only wise when these investments are balanced by potentially more stable large-cap and mega- cap holdings.

Market Caps and Portfolio Diversification 

Determining the balance of a portfolio, taking market caps into consideration, comes down to an investor’s time horizon, tolerance for risk and goal structure. 

Early-stage long-term investors, seeking to build retirement income, could probably withstand a degree of the fluctuations inherent to a small and micro-cap strategy to capture their exceptional growth potential. 

Investors looking for better gains with a lower degree of risk might gravitate toward equities issued by mid cap companies. Meanwhile, investors for whom stability is paramount would likely be more comfortable with large cap and mega cap holdings. 

Portfolio Diversification and Alternative Investments

As stated, market cap can be a useful metric by which to choose equities with which to diversify an investment portfolio. Traditional asset allocation envisions a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split incorporating 20% alternative assets may make a portfolio less sensitive to public market short-term swings. 

Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.

Alternative assets were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors who buy in at very high minimums — often between $500,000 and $1 million. Yieldstreet was founded with the goal of dramatically improving access to alternative assets by making them available to a wider range of investors. 

Market Cap Limitations

While a commonly employed metric, the limitations of relying upon market cap alone must be highlighted. Most significantly, market cap fails to consider a company’s debt load and cash position. In other words, a company with a high market cap can also have great deal of debt and a relatively small amount of cash on hand.

These considerations still could make a company with a large market cap a riskier investment. Simply put, considering market cap alone when deciding whether to purchase a stake in a company is less than prudent

Experienced investors also consider a company’s enterprise value, as this metric also factors in debts, assets, and cash holdings. Additional factors to consider include financial performance data, investor and consumer confidence, as well as government policies. Potential interest rate changes, technology advancements, economic climate, inflation, and changes in supply and demand also come into play.