Ball Cap, Bottle Cap... Market Cap?
What size is your market cap? Prudent investors know that company size is an important factor when building a portfolio. Large established companies tend to be more stable and predictable, while small companies with unproven potential can be risky investments. Is your market cap a good fit for you?
When it comes to the companies in your portfolio, size matters! Weight your portfolio too heavily with companies of one size and your retirement funds could be exposed to unnecessary risk or produce lackluster results. Confused about market cap? Here's what you need to know.
What Is Market Cap?
Market capitalization, or market cap, represents the total value of a company. Some investors make the mistake of assuming a high stock price means a high company value. Not true. The stock price actually tells you very little about its value. The company's market cap, however, represents the total value of that company’s equity shares.
Here’s an example:
- Company A has approximately 4.2 billion equity shares with a current market price of $48 per share. By multiplying the number of shares by the price per share, we determine its market cap is approximately $200 billion.
- Company B has 28 million equity shares with a current market price of $312 per share. Its market cap is approximately $9 billion.
In this example, Company A is the tech giant Oracle. Company B is Chipotle Mexican Grill restaurant chain. Chipotle's share price is currently more than six times Oracle's share price. But Oracle has a market cap that is more than 20 times that of Chipotle. We would all agree that market cap is the appropriate indicator of a company’s value, not its individual share price.
Why Does Market Cap Matter?
Market cap measures what a company is worth on the open market. It also measures the market’s perception of a company’s future prospects, since it reflects the value investors place on its stock. Investors can use market cap as one way to diversify their portfolios.
There are three generally accepted ranges or categories to describe market cap:
- Large-cap companies. Generally defined as having a $10 billion or more market cap, these companies are often nationally recognized household names with a reputation for producing quality goods and services. As dominant players in established industries, they typically demonstrate a history of consistent dividend payments and steady growth. Large-caps are considered the least risky among equity investments. The trade-off: less aggressive growth potential.
- Mid-cap companies. Generally considered to have a total value in the $2 billion to $10 billion range, these companies are typically well established and are in industries experiencing or expected to experience rapid growth. A mid-cap company tends to be one in the process of increasing its market share and overall competitiveness. This stage of growth is likely to determine whether the company will live up to its full potential. Compared to large-cap companies, mid-caps tend to have more risk, but a greater potential for return.
- Small-cap companies. With a value generally in the $300 million to $2 billion range, small-cap companies are often young companies found in niche markets or emerging industries. They're considered the most aggressive and risky of the three categories. Compared to mid- and large-cap companies, these firms have limited resources, making them more susceptible to a business or economic downturn. They are also vulnerable to intense competition and uncertainties. On the plus side, small-cap companies offer significant growth opportunity for long-term investors who can stomach volatile swings in the short term.
Which Cap Is Right for You?
That’s a trick question! Your equity portfolio should contain more than one market cap. Why? Companies in each of these three categories will react differently in various market environments.
If you are over-exposed in risky areas, your portfolio could take a huge hit when you least expect it. If you construct your portfolio too conservatively, your investment return can suffer when risk-averse assets are performing poorly. However, pairing risky stocks with more stable investments can potentially boost your portfolio's long-term return.
To build a portfolio with a proper mix of small-, mid- and large-cap stocks, you'll need to evaluate your individual financial goals and risk tolerance. A diversified equity portfolio that contains a variety of market caps helps reduce your investment risk in any one area and supports the pursuit of your long-term financial goals.