What Are Market Capitalizations?
Hi everyone, and welcome back to Melissa Making Cents!
As a CERTIFIED FINANCIAL PLANNER, one significant aspect of my job is educating my clients! This is a responsibility I take very seriously and is why I often cover some financial basics through my blog posts. Most recently, one of the educational blog topics that I've covered are Penny Stocks! If you're interested in learning more about them, check that post out here. However, it doesn't stop there - Recently, I've covered everything from Phantom Income to Mortgages!
Being a financial coach, I understand that people come in all shapes, sizes, ideologies, situations and just about every other imaginable difference you can think of. For those interested in investing, it's essential to understand that companies, businesses, and corporations can be very different also. Of course, there are all sorts of methods and systems that you can stick to that will help you sort out this company from that company. However, when talking about investing, one metric that pops up (a lot) is Market Cap or, more specifically, Market Capitalization.
Join in today as we discuss what a market cap is and general information about it. We'll also discuss different types of market capitalizations and how they affect investors and their investing plans. This ought to be a great blog topic jam-packed with some great information!
Market Capitalizations General Summary
Market Capitalization is one method to accomplish a goal that can be achieved in many different ways. Often when something is both important and complicated several strategies to take on the task will emerge, which is essentially what is happening here. The goal of market capitalization is to capture the value of a company at a specific moment. Unfortunately, like every method of assessing a company's value, Market Capitalization falls short in various ways, which we'll discuss later on.
The mathematical formula for Market Capitalization is MC=NxP. Don't worry, I don't expect you to understand that right off the bat, let's explain. You've probably already figured out that MC in this formula stands for our topic of discussion, Market Cap. N is the number of outstanding shares, while P is the market price per share. So, if you multiply the market price per share by the number of shares outstanding, you're left with market capitalization! As far as math and finance go, this formula is relatively simple. So, let's tackle this with a (fake) example.
If you're a company with 1,000 shares outstanding, and the price of your shares is $2.00/share, then your market cap would be $2,000.
Why Market Caps Matter
Some would argue that Market Caps don't matter. However, for those who believe in the information they give us - a market cap paints a picture. For starters, we need to understand something. Remember when I was sort of defining what a Market Cap is, and I said, "… capture the value of a company in a specific moment"? A Market Cap paints a picture of a snapshot in time for us. As the price of shares in a company fluctuates, the overall Market Cap will change. According to NerdWallet, “The size and value of a company can affect the level of risk you can expect when investing in its stock, as well as how much your investment might return over time. Categorizing companies this way helps investors create a balanced portfolio that's optimized for long-term growth.”
However, in the current moment that we measure market capitalization, we're given a glimpse into what a company is worth. This is especially helpful when benchmarking companies against each other as market capitalization can give us an idea of whether two companies being considered for investing are even in the same ballpark. Market capitalization also gives us an idea of what people are willing to pay to be invested in a company, which is essential considering that a large part of investing is subjective.
In other words, if a company is seemingly large but has a small market capitalization, we can sort of say to ourselves, "Hey, something seems off here." Or, if the reverse is true, we can speculate that something may be happening to cause this company to shoot up in value over time. Either way, Market Capitalization gives us an indication that more digging and examination may be required.
Market cap also gives us an indication of how well our own portfolio is diversified. As you may know, diversification is the act of having varying forms of investments in a portfolio, which mitigates certain risks for us. One way that we want our portfolio diversified is by how many assets we have in each segment of the market cap. In other words, we want to make sure we have a certain amount of large, medium, and small company investments.
Different Types of Market Capitalizations
The next thing we need to discuss about market caps is the different segments of businesses. Essentially, these are the various categories a company or business will fall into based on its market capitalization. So if you're an investor who's interested in diversifying your portfolio in part based on market cap, these are the categories that you'll need to pay attention to do this.
Micro Cap ($50-300 Million) & Nano Cap (Sub $50 Million)
The smallest of the market capitalization segments are Micro Cap businesses. When comparing companies off of market capitalization and their market cap, these are the smallest of the smalls that can land anywhere from fifty million dollars to three hundred million dollars. While that seems like an awfully lot of money to be defined as micro, these segments are based on relative market capitalization between various businesses. A lesser-used segment that refers to anything under the 50 million dollar market capitalization benchmark is nano-cap.
For most investors and financial planners, nano and micro-cap businesses can be utilized in small amounts. While they have large growth potential, they're statistically more volatile businesses, which translates into share price volatility which can cause short-term price swings. The amount of micro and nano-cap businesses an investor may want in their portfolio depends heavily on their risk tolerance.
Another factor that comes into play with micro and nano-cap businesses is the potential for fraud and pump and dump schemes to work their way into the mix. Because of this, any micro or nano-cap company that one is planning on investing in should be heavily and extensively researched. This, mixed with the fact that there is less demand for micro and nano-cap shares, means that it can be challenging to sell your shares in companies like this, a concept referred to as illiquidity.
Small Cap ($300M - 2 Billion)
Small-cap shares some characteristics of nano and micro-cap businesses, but with a little less risk and volatility. While these companies certainly have limited information and are open to some forms of less than scrupulous practices and risk, the likelihood is decreased. Small-cap businesses are generally considered to be anywhere between three hundred million two billion dollar market capitalization.
Companies that fit into this category are generally reasonably new to the market and are emergent. This means that the probability of them taking risks to gain market share is higher. In turn, this means that you can expect a larger amount of volatility in their prices than you would from a medium or large-cap business. Because of small-cap aggression and limited resources compared to large and mid-cap companies, this segment can also be more susceptible to economic downturns that may be endured by larger businesses.
On the upside, successful small-cap businesses could lead to high long-term returns, though they make create losses short term. These are obviously slightly less risky than micro and nano-cap companies, but they come with their fair share of risk, illiquidity, and lack of information.
Mid Cap ($2 -10 Billion)
Mid-cap businesses fall anywhere between two billion and ten billion dollars. Many see this level of company as being in the make-or-break stage of their lifespan, which will result in them turning into large-cap businesses or dwindling down over time. Thus, the risk in this category is (as the name suggests) mid-tier. While there is undoubtedly still risk, as there is in every investment, it is less than that of small, micro, or nano-cap. The potential return for mid-cap businesses is also limited but can be higher than that of large or mega-cap companies.
To characterize companies in the mid-cap level, you'd expect to see a reasonably well-established business that's entering either a growth phase or a dwindling phase. Working with your financial planner, you should be able to decide on an individual company basis to figure out whether or not these types of businesses will be worth your investment.
Large Cap ($10-200 Billion)
A large-cap business will be one with a market cap in the neighborhood of ten to two-hundred billion dollars. As you can imagine, these are well-established companies and have most likely been around for a while. One good thing about investing in large market cap businesses is the minimization of risk. While there is undoubtedly still risk to be had, it is minimal compared to mid, small, micro, and nano-cap businesses.
On the other hand, businesses in the large-cap category have largely experienced the majority of their growth phases. They'll still likely experience steady growth, but it won't be as explosive and quick as it would potentially be in smaller cap businesses. Companies that would fit into the large-cap category are businesses like Walmart, Johnson & Johnson, or other prominent and household names.
Generally considered safe, large-cap investments are a great long-term investment option. Because of their lower growth rate, it's unlikely they'll make you a millionaire overnight, however with the right investment strategy, diversification, and reinvestment, one could potentially amass considerable gains over a long period of investment with companies like these.
Mega Cap (Over $200 Billion)
Mega cap businesses are the largest of the large when it comes to market capitalization. These businesses are valued at 200 billion dollars or higher and are some of the most recognizable brands in the world. Yet, they're also the smallest segment when it comes to businesses included in their category. This is understandable, especially taking into account the considerable amount of money enveloped in their market cap.
In today's world, businesses in the mega-cap segment are often those in the technology sector, such as Apple, Facebook, or Alibaba. However, in the past, this segment was comprised of energy and transportation businesses. Investing in these businesses doesn't come without risk. While you're unlikely to experience too much downturn, it's always a possibility.
These are Just General Thresholds
As a last note about the different segments companies may fall into based on their market cap, it should be said that these classifications are generalizations. In other words, the definition of what exact parameters create a large, small, or mid-cap business may change depending on who's defining them. While there may be variance between definitions and parameters, these thresholds are more or less accepted with minor discrepancies.
Pitfalls of Market Capitalization
Now that we've defined market capitalization, set parameters, and talked about what market cap can be used for, it's time to mention some of the negative sides of market cap. One of the most notorious pitfalls of market capitalization as a measurement is that we're looking at a snapshot in time. While the company's market cap may be very high one day, several months down the road, it could look quite different if a company-issued more shares, bought back shares, or the price of shares dropped significantly depending on inside or outside influences.
One reason market cap is scrutinized is the lack of a universal definition for its segments/categories. While if you're working with a single financial coach or financial planner or a team who are all on the same page, this shouldn't be much of an issue - if you're working with multiple people or teams who have different parameters of market cap segments, this could cause problems with proper diversification.
Another criticism of market capitalization is that it's entirely dependent on market valuation and may not adequately assess how much a company is worth. Because the market cap calculation is based on the price and number of shares available, and share price can be over or under-valued, the overall market cap of a company may also be over or undervalued. A prime example is in the nano, micro, and small market cap segments, where share price can be highly volatile.
It is also argued that more comprehensive calculations should be considered that take more information into account. However, a proper financial planner or financial coach will help you see the broader picture by pairing metrics like market capitalization and metrics like enterprise value and market value.
Market Cap V. Market Value
An important distinction to be made is that of market capitalization (market cap) and market value. These two terms are often used by investors and speakers completely interchangeably; however, some very fundamental differences should be noted. As we've discussed, market capitalization, or market cap, is the number of outstanding shares multiplied by the market price per share.
Market value, on the other hand, is the value of the company as a whole. While market cap is more of a metric that can be used to determine what segment a company falls into, market value is more of an estimate of the company's overall worth. Market value can change based on various factors like debt, growth rate, equity, and earnings taking much more into account and creating a more detailed, comprehensive figure than the market cap.
If you'd like to learn more about Market Cap, Market Value, investing, or risk, please, feel free to call or email to schedule an appointment with me. Together we can create a financial plan that helps you make the most out of your money and investments.
Until next time...this is Melissa Making Cents!
Melissa Anne Cox, CERTIFIED FINANCIAL PLANNER™, is also a College Planning and Student Loan Advisor and Financial Coach in Dallas, Texas.
