Market Capitalization and its Role in Investment Strategies

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Market Capitalization represents the total dollar market value of the total number of shares of a company. Also called market cap, it is determined by multiplying total number of outstanding stock and the price of one stock in the market.

For an example, a company that has 1 million stocks each priced at $100 would have a market cap of $100 million. Market cap is used to determine a company’s size in contrast to its sales value or total assets outstanding value. It is therefore a very important figure for a company’s value for the investors.

In times of acquisition, market cap lets the investor know whether a price of the investment is worthy for a certain company it wants to invest in. According to the market cap, companies are divided into three categories −

  • Large-cap companies have a market cap of $10 billion or more

  • Mid-cap companies’ market capitalization is in between $2 billion to $10 billion.

  • Small-cap companies have a market cap of $300 million to $2 billion.

Usability of Market Capitalization

Market capitalization is a worthy tool to determine a company’s value quickly and logically. Without market capitalization, it would be very hard to ascertain a company’s value that is traded in the share market. The companies share value is the price investors think correct and hence it truly represents the best value of a company when multiplied by the number of shares there are in the market.

Investors are interested in market cap for a host of reasons. For example, it is important to ascertain the characteristics the company may have, including risk and size. It is also very easy to calculate and hence offers a reasonable advantage to calculate a firm’s market value within a short span of time.

For example, a company having 20 million shares each having a value of $100 would have a market cap of $2 billion while another company with 2 million shares worth $1000 would also be worth $2 billion.

A company’s market cap is first established via an Initial Public Offering (IPO) in the share market. For this companies employ an investment bank to start evaluating the company.The investment bank determines what the final value of a company is and depending on that, the company decides how many shares to offer to public via shares market.

For example, a company that has been priced worth $100 million may wish to offer 10 million shares $10 each or it may off 20 million shares worth $5 each. Once the IPO occurs, the price of the share is decided by supply and demand in the market. In case of high demand, the price of share goes up while in case of low demand the share prices go down. The market cap then becomes a real time affair with the price of shares changing according to demand and supply of shares.

Investment Strategies Depending on Market Cap

Market cap usually offers a super easy way to determine a company’s value and invest in that company publicly. It is easy to see whether a company’s market cap is growing over time to decide for an investment strategy. The rules for investment in different market cap companies are different but each has inherent advantages and disadvantages.

Large cap companies are worth $10 billion and more and they are big companies with power to move the markets. These big companies have larger share prices and the return on investment in these companies is low. However, they can offer a stable income and return over a longer period of time and hence are better bets for investors looking for returns in the long term. Examples of large cap companies are Microsoft, Tesla and Intel.

Companies having market cap of $2 billion to $10 billion are mid cap and they offer good return in shorter period of time. However, they carry higher risks as they are not fully established yet. Mid cap companies work in fast growing industries but investing in them requires caution and knowledge of the given industries the companies work in. An example of Mid cap company is Flex Ltd.

Companies having market cap between $300 million and $2 billion are small cap and they are niche firms working in smaller and more focused industries. They offer high returns but are also the riskiest. The prices of these shares are low and they suffer from largest volatility in the market.

There are even smaller companies worth $50 million and $300 million known as micro cap and they are the smallest in size according to market cap. These are the stocks that offer very high return but they are very risky to invest in too.

Overall, the mix of companies from all categories should be better mixed for a steady growth and return on investments.

Market Caps Notions

Market cap does not represent the equity value of a company. The equity value is determined according to company fundamentals. As only share value is unable to show the real value of the company, market capitalization cannot be accounted for the real value of the firm in general.

Share prices may be under or overvalued and hence only shows what the costs of shares are worth in a market that is largely driven by demand and supply. In case of merger transactions, market cap is unable to show the appropriate value. In such cases Enterprise Value is a better alternative.

Market Caps Changes

The market cap usually changes due to an increase or decrease in the number of shares. An investor using increased number of warrants can increase the number of shares in the market. It affects shareholder income and the process is called dilution.

Key Takeaway

There are advantages and drawbacks of using market cap alone as a benchmark for investments. While it does offer a quick way to determine the market value of a company, market cap is fully dependent on share and stock and does not provide all real factors in account to take a decision regarding investments in a given company.

raja
Published on 27-Jul-2021 10:05:06

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