What is Market Cap and How to Use it in Investing

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market capitalizationMarket capitalization might seem like a scary complicated term, but it is actually rather simple.

Not only is it simple, but it is a great tool to use when you are working on diversifying your investments.

So let’s dig and find out exactly what it is and how you can use it.

What is Market Cap

Market capitalization may also be heard as: market cap or mkt cap.

This is the amount of money that a company is valued at on the stock exchange.

It is calculated by taking the price per share and multiplying by the total number of shares outstanding.  For example: Stock Y has a share price of $10 and has 20,000 shares outstanding.  The market cap is $200,000.  This value does change daily depending on the new share price.

Market Cap Categories

Market capitalization is broken down into different categories to help you differentiate different sizes of companies.  (Note:  there are no set dollar amounts for the categories; these are suggestions that many analysts use, but can vary from firm to firm.)  Most investment information will only focus on the large, medium and small cap categories.

Mega/Giant Cap:  Companies valued at $200 Billion and up.  There are not many of these, in fact many research sources will not break these out of the large cap grouping since there are only a handful of them.  Examples of a mega cap companies are GE* or Apple*.

Large Cap: Companies valued at $10 – $200 billion.  These tend to be your established market leaders, often referred to as Blue Chip stocks.  Most large cap stocks have less volatility than your medium and small companies.  An example of a large cap is John Deere*.

Medium Cap: Companies valued at $2 billion – $10 billion.  An example of this category is Abercrombie & Fitch*.

Small Cap: Companies valued at $300 million – $2 billion.  These companies tend to be newer companies and are still growing.  They tend to have more risk associated with them than your large cap stocks.  However the rewards tend to be higher to compensate for the risk taken with these stocks.  An example of a small cap is Angie’s List*.

Micro Cap: companies valued at $50 million – $300 million. These often tend to be penny stock companies and are very risky. Many are traded over the counter and not on an exchange.  In order to remain on an exchange companies have to meet minimum market cap, stock price and other factors, if you want more information you can read this from the NYSE.  An example of a micro cap is Harbor Brewing Co., Inc.*

Nano Cap: companies under $50 million.  These are typically not on a “major” market such as Wall Street and instead are traded in pink sheets or over the counter trading.  These are very risky and often thinly traded.   When looking at mutual funds, most will not invest in these, as they are typically not allowed to own too much of one company.

What Market Cap is Not

While market cap gives you what the stock market values the company at, it is not the actual value of the underlying company.

Instead it is a measure of what the overall market thinks its value is today combined with its’ possibilities for tomorrow.

You can look at market/book ratio to determine if the market is overvaluing or undervaluing a company.  Ultimately until a company sells you can never have an exact estimate on it’s true worth, as too many variables need to be taken into consideration.  It may be easier for you to think of market cap as a measure of company size instead of the companies’ worth.

How to Use Market Cap when Investing In Mutual Funds

The best use of market capitalization when you are determining what mutual funds to invest in is to use it to help control your allocations.  You don’t want your portfolio to be completely in large cap or in small cap stocks.  Instead you want to balance this across the categories to meet your preferred risk level.  The more small and mid cap mutual funds you have the riskier your portfolio.

This also helps you minimize the number of funds that you need to sort through when selecting a new fund.  By deciding that you want small cap or mid cap stocks you will eliminate thousands of funds.

When first starting to build a portfolio sway towards the larger side of the capitalization sector, since these companies tend to bit a bit more stable.  Then as your assets grow you can diversify more into the smaller cap funds.

When you are investing in individual stocks you will need to learn more about how to look at market cap compared to the book value of the company.  Check out Morningstar’s Investors’ classroom to learn more.

I have also put together the following video on what to look for at Morningstar when looking at mutual funds and the fund’s target market cap, click play below and happy investing!

 

*Stocks/Funds mentioned in this post/video are for examples only.  They are neither recommended or not recommended for purchase.  Market cap values taken from August 28, 2012.  Morningstar is an affiliate link if you sign up for an account.

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