Market cap, short for market capitalization, is a method that allows investors to determine the total value of a company on the stock market. While the term itself might sound technical and intimidating, calculating market cap is simpler than you might think.
Market cap is the total value of a given company, as determined by the market. This is calculated by multiplying the market value of one share by the total number of shares.
Think of it like a mathematical formula:
Total number of pieces of the pie X Cost of each piece = Market cap of the whole pie
Market cap can help us understand how much companies are worth because individual share prices can be misleading.
Consider the cutthroat-competitive frozen pie industry. One company, Granny’s Apple Pies, is worth $100.00 a share, while Auntie’s Apple Pies are worth just $75.00 a share. Based on this limited information, we might thus incorrectly deduce that Granny’s company is worth more. This is because we did not take into account an important factor of this equation when determining company value: total outstanding shares.
That is, how many slices is each company cut into? It turns out that Granny’s Apple Pies has 100,000 shares, while Auntie’s Apple Pies has 200,000 shares. While each slice of Granny’s company is worth more, it turns out that Auntie’s figurative whole pie actually has a greater market cap.
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It makes sense that some companies have greater market cap than others. Figuratively speaking, you might expect that a rare mango cardamom pie in a gold leaf tin might go for more than your standard pumpkin pie. But for investors who are only purchasing individual slices, what does the value of the whole pie matter?
Consider these key points when thinking about the role market cap should play in your investment plans.
Is bigger always better when it comes to market cap?
Companies are generally divided into three categories based on market cap. Small companies have a cap of less than $2 billion, medium between $2 and 10 billion, and large above $10 billion. The size and nature of companies in each category are associated with unique advantages and disadvantages.
Smaller companies are generally younger than larger companies. As such, they have great possible growth potential (and thus earning potential for investors). For the same reason, they can also be more volatile.
Companies with mid-sized caps tend to have more growth potential than their larger counterparts, while also tending to be more stable than smaller companies.
The largest companies tend to have the lowest volatility and may even fair better through market ups and downs. However, shares of large cap companies are often much more expensive than shares of small caps.
Should I “go big or go home” with market cap?
Not necessarily. The market is unpredictable and a recession may be on the horizon. As such, it’s often advisable to diversify your investment portfolio in order to prepare for a market that may boost large, medium, or small market cap companies.
The exact content of your investment portfolio ought to take into account your financial risk tolerance, short and long-term goals, and, of course, the actual amount you have to invest. Financial advisors can help you to understand all of these factors.
When considering investing opportunities, it’s important to learn about the whole pie itself, not just the individual slices you’re drooling over. Use market cap as a tool to help you quickly understand more about a given company’s volatility, possible productivity, and other factors!