What Market Capitalization Means for a Stock Trade
Investors analyze many different aspects of a stock before deciding whether or not it’s a worthwhile investment. Ratios such as price-to-earnings, price-to-sales and debt-to-equity are poured over while financial statements are reviewed from past quarters to determine trends. But one important thing that seems to go unnoticed often is the company’s market capitalization.
Market capitalization is the value of a company that’s traded on the stock market, which is determined by multiplying the total number of shares by the current stock price. So a company with one hundred million shares trading at $20 per share would have a market cap of $2 billion. It might seem superfluous to know what the market cap of a stock is, but it can actually reveal more about the company than you realize.
Market Capitalization as a Metric
Far from being insignificant, understanding market cap is essential in building an investment portfolio. Diversification doesn’t just mean investing in stocks in different industries, it also means investing in companies of varying size. Small cap, mid cap and large cap stocks all need to be present in a portfolio to truly be diversified.
Market cap is also correlated with volatility. Companies with a smaller market cap tend to be more volatile than larger ones. This can usually be seen by comparing market cap with a stock’s beta. By keeping your portfolio exposed to companies with varying market caps, you can take advantage of growth without taking on undue risk.
The size of the company tends to matter more for growth stocks than value stocks. Because growth strategies require fast growth from a company, a smaller market cap means more opportunities for growth, whereas larger companies might not have room for continued expansion at an accelerated pace. But companies that are too small might not have the ability to make investments or acquisitions that can generate the kind of growth needed.
Another important correlation is a company’s market cap and international exposure. Larger companies tend to have more international business dealings, leaving them vulnerable to foreign currency risks, whereas a smaller company might not have the resources to expand to overseas markets yet. Knowing the market cap of a stock can let you know how much foreign exchange risk might affect your portfolio.
Certain types of trades are dependent on market capitalization. Speculative stocks, for example, are almost always small cap stocks that have potential for exponential growth. Dividend paying stocks on the other hand are generally large cap stocks that have enough income to pay a dividend to investors.
When building a portfolio, it’s important to take market cap into consideration. Lowering risk through size diversification can prevent being overly exposed to a particular kind of risk.