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Market Capitalisation: A Good Indicator for Purchasing Stocks?

October 08, 2020 10:45 UTC

If you read articles about the stock market or the economy, you will probably have come across the term "market capitalisation" at some point. But what is market capitalisation? And what can it tell you about a company?

In this article, we will look at these questions as well as how to use market capitalisation to group companies into different categories, whether it is a good indicator for purchasing stocks and more!

What is Market Capitalisation

What is Market Capitalisation?

Market capitalisation, sometimes shortened to "market cap", is the total market value of a company's outstanding shares, usually expressed in the currency in which the company's shares are listed. The figure can be arrived at by multiplying the number of outstanding shares by the current market value of one share.

For example, let's say that Company X has 500,000 shares outstanding at a current market value of $100 per share. The market capitalisation of Company X would be $50 million (500,000 x 100).

A company's market capitalisation indicates its overall size. This can tell a potential investor a lot about the prospect of investing in the company, which we will look at in detail later.

Changes in Market Cap

In the calculation of market capitalisation, there are two different variables:

  • Number of shares outstanding
  • Share price

When either one of these two variables changes, so too does the market cap.

The share price of a publicly traded company is constantly changing based on the levels of supply and demand in the market. As a company's share price fluctuates throughout the day, its market capitalisation fluctuates along with it.

The other variable, total shares outstanding, does not change nearly as often as the share price, however, it can be altered from time to time.

For example, companies may sometimes issue new stock, increasing the amount of shares outstanding, or repurchase shares, reducing the number of shares outstanding. Whatever the reason, when the number of shares outstanding changes, the market capitalisation will adjust accordingly.

Stock Splits - The Exception

The exception to the above changes is when a company splits its stock. When this happens, the company increases the number of shares in circulation, however, at the same time, the share price is reduced proportionately to ensure that market capitalisation remains the same.

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Market Cap vs. Share Price

It is common for people to think that a company's share price is reflective of how large, successful or valuable a company is. But this is not necessarily correct. Market capitalisation gives a much more accurate picture of the success and size of a company.

For example, let's compare two companies:

Company A:

  • Share price = $100
  • Shares outstanding = 100,000
  • Market capitalisation = $10 million

Company B:

  • Share price = $50
  • Shares outstanding = 500,000
  • Market capitalisation = $25 million

Despite Company A's higher share price, Company B has a much larger market cap, which tells us it is more valuable and successful than Company A.

Market Cap Categorisation

Investors traditionally categorise companies into large-cap, mid-cap and small-cap. More recently, the terms mega-cap, micro-cap and even nano-cap have also become widely used.

Below is a table which shows how these different categories are typically defined.

Category

Market Capitalisation Range

Mega-Cap

More than $200 billion

Large-Cap

$10 billion - $200 billion

Mid-Cap

$2 billion - $10 billion

Small-Cap

$300 million - $2 billion

Micro-Cap

$50 million - $300 million

Nano-Cap

Less than $50 million

It is common for companies to move through these categories, as they grow in size or depreciate in value over time.

What Does This Tell Potential Investors?

Market capitalisation gives us an indication about the overall size of a company. But what can a potential investor take away from this? You can tell a lot about an investment's potential risk and reward from the market capitalisation.

Smaller-Cap Companies

Investment in companies with small market capitalisation carries a higher level of risk than those further up the scale. However, with a higher level of risk also comes a higher level of potential reward, as smaller companies have more room to grow.

The companies which have lower market caps are more susceptible to being pushed out of the market by competition from other small companies or larger companies diversifying their business to establish themselves in a different industry. They are also more vulnerable to economic downturns or recessions due to their lower levels of resources when compared to larger companies.

However, if an investor picks the right company, investment in a small-cap company can be rewarded exponentially. For example, when online retailer Amazon went public in 1997 for an initial offering of $18 per share, they were a small-cap company, with a market capitalisation of around $438 million.

Fast forward to October 2020 and Amazon shares are currently trading at around $3,140 and their market capitalisation is a staggering $1.565 trillion. A $1,000 investment in Amazon back in 1997, at the initial offering price, would be worth around $2.07 million today, adjusting for stock splits.

Amazon Daily ChartDepicted: Admiral Markets MetaTrader 5 - Amazon Daily Chart. Date Range: 22 December 2011 - 8 October 2020. Captured: 8 October 2020. Past performance is not necessarily an indication of future performance.

Trading Small-Cap Companies

Companies with small market capitalisation are likely to have more volatile share prices. The high risk, high reward nature of these stocks makes them more appealing to short-term traders who are looking to profit from volatile markets

Large-Cap Companies

In general, companies which have a large-cap, or mega-cap, are well established in their particular industry. The shares from these types of companies are sometimes called "blue chip" stocks.

An investment in these companies carries lower risk than others, as they have already achieved a certain level of success, beaten off competition and cemented their position as market leaders.

However, whilst investments in larger-cap companies carry less risk, they also have lower potential reward as these companies tend to experience slower growth than others. The reason for this being that, by definition, these larger-cap companies have already achieved success and, therefore, already experienced high levels of growth. When businesses reach this level, growth inevitably slows down.

Investing in Large-Cap Companies

Due to their lower risk and steady growth, large-cap companies represent an ideal opportunity for people who are looking for a long-term investment.

Companies with high market capitalisation are also more likely to issue dividends to their shareholders, making them better candidates for income investments.

By trading shares with Contracts for Difference (CFDs), traders not only benefit from the use of leverage, but are also able to profit from both rising and falling prices.

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Free Float Market Capitalisation

Another, related, term you may have come across, particularly when dealing with stock indices, is the "free float" market capitalisation.

Whereas the market capitalisation takes into account all outstanding company shares when calculated, the free float figure only uses the shares which are freely traded through stock exchanges. In other words, it excludes any shares "locked in" and held by company management, controlling parent companies or governments.

Companies which have a small free float market capitalisation in comparison to their market capitalisation, are likely to have a more volatile share price. This is because there is a smaller supply of shares in the market to accommodate any significant changes in demand.

Indices and Market Cap

Many of the world's most popular indices use market capitalisation to determine which stocks should be included in the index – and in what proportion.

For example, Britain's FTSE100 is comprised of the 100 largest companies listed on the London Stock Exchange, as determined by market capitalisation. To qualify for inclusion, the companies should also have a minimum 25% of shares in free float.

The growth of passive investing and tracker funds means that a growing proportion of investor money blindly (or passively) follows indices. A FTSE100 tracker fund and many ETFs (Exchange-Traded Funds), for example, have to invest their money to hold all of the shares in the FTSE100 index.

This means that if share price changes lead to Company X being ejected from the index and replaced by Company Y, FTSE100 trackers have to sell X and buy Y. This, in turn, means that it is very likely that the share price of Company X will fall and the share price of Y will rise when FTSE announces these changes to its index.

If you want to learn more about trading with the FTSE100, read our article 'How to Trade the FTSE100'.

MetaTrader FTSE100 Daily ChartDepicted: Admiral Markets MetaTrader 5 - FTSE100 Daily Chart. Date Range: 20 August 2019 - 6 October 2020. Captured: 6 October 2020. Past performance is not necessarily an indication of future performance.

Many traders and investors try to benefit from these somewhat predictable share price changes by anticipating index reshuffles (who will be "in" and who will be "out") and making corresponding trades.

For the S&P 500, inclusion is less mechanically tied to market capitalisation as the criteria includes other factors like liquidity, industry and the proportion of assets held in the US.

Nevertheless, traders still try to guess which stocks will be included in each of the S&P 500's quarterly reshuffles.

A Good Indicator for Purchasing Stocks?

Whilst market capitalisation can provide an investor with a good indication of a company's risk vs. reward profile, it should by no means be used on its own when evaluating the merits of a potential investment.

If you are looking to profit from a share's volatility, then smaller cap companies are likely to be more attractive for you. But, in this case, you will also want to look at other factors such as news and recent moves and trends in the share price.

On the other hand, if you prefer to make long-term, low risk investments, then large caps are likely to be more suitable. However, it is important to look beyond market capitalisation and delve deeply into the fundamentals of a company and its current share price before deciding whether or not it is a worthwhile investment.

In neither case will market cap on its own give you the complete answers you are looking for.

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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.