Investing 101: Defining Market Capitalization

(iStockphoto)

Even if you’re an investing newbie, you’ve probably heard the term market capitalization. Commonly known as “market cap,” it is basically the measurement of a corporation in real dollars.

It’s important because it gives us an idea of how large a company is and, in turn, allows us to compare it to other companies of similar size. (Hence the popular large-cap, mid-cap and small-cap categorizations, which we’ll define below.)

When you see a share price of stock it does not reveal the overall size of a company. For example, if one company’s stock is worth $40 per share, it is not worth twice as much as another whose stock is worth only $20. The true measure is the result of multiplying the share price by the number of outstanding shares.

Consider two fictional companies whose stock is now worth $40 and $20, respectively, but the company with the more expensive stock has fewer outstanding shares:

$40  x  60 million shares  = $2,400,000,000

$ 20  x 120 million shares = $2,400,000,000

In this example, both companies have the same market cap, even though their share price is quite different.

Several distinctions are made to define market cap. The most basic of these is the division between large cap, mid cap and small cap. Large cap companies have total market cap above $8 billion, according to Morningstar. Most of the companies whose names are recognized by the public fall into this category, including all of the DJIA 30 industrial stocks.

Mid cap ranges between $1 and $8 billion, and this group there tends to be typically made up of a lot of technology and Internet companies. (Of course, there are mid-cap companies in all sectors.)

Small cap companies are those under $1 billion. These include very young and new companies and those still on a growth curve. Remember, every big cap and mid cap company started out as a small cap.

Some analysts like to further define these ranges. For example, some definitions include mega cap (companies over $100 billion in market value) and micro cap (those under $100 million).

These size distinctions are important as one of many measures of risk and opportunity for growth. For example, as a generalization, many investors view large cap corporations as safe but slow-moving, so growth will not be likely to occur rapidly. In comparison, small cap companies are more likely to experience very rapid growth, but market risks are considerably higher.

As a method for evaluating market risk and deciding which level is appropriate, market cap is a good place to start. The distinction is popular among mutual fund investors, who may divide their funds between large and mid cap funds, for example; or for the more aggressive, may select a fund specializing in carefully selected small cap companies.

The same distinctions can be made when investing in individual stocks. Remember, capitalization size is not just about the worth of a company; it is a reflection of potential growth, and the flip side of that potential is the level of risk.

Using capitalization size as a starting point in picking stocks is sensible. For example, an investor might decide to invest only in mid size companies, reasoning that this is a logical middle ground between growth and risk. Within the mid cap realm, the investor can then search a shorter list using other criteria, such as revenue and profit growth, working capital trends, competitive position within an industry, dividend yield, and other trends. Starting out with market cap is a wise decision.

Michael C. Thomsett is author of over 60 books, including Winning with Stocks and Annual Reports 101 (both published by Amacom Books), and Getting Started in Stock Investing and Trading (John Wiley and Sons, scheduled for release in Fall, 2010). He lives in Nashville, Tennessee and writes full time.

Investing 101: Defining Market Cap was provided by Minyanville.com.