Explainer: What is a market cap and why is it important?

Whilst the first visual point of call when observing a publicly traded company online is its share price and chart, perhaps the most indicative and telling value for any investor is the market capitalisation.

As stocks represent ownership in companies of various sizes, it is imperative to have a strong understanding of the relationship between company size, return potential and risk when creating a long-term investment strategy.

Market capitalisation refers to the total dollar value of a company’s outstanding shares as determined by the stock market.

Commonly referred to as ‘market cap’, this valuation serves as a quick and easy alternative to sales or total asset figures to gauge a company’s worth by extrapolating what the market thinks it is worth for publicly traded companies.

It is simply calculated by multiplying the total number of a company’s outstanding shares by the current market price of one share.

Market cap = share price x # shares outstanding

For example, a company with 1 million shares selling for $5 each would have a market cap of $5 million.

Using market capitalisation is also a favourable technique for investors as company size determines other crucial considerations such as risk, and provides an easy means to be able to compare values of different companies.

How is a market cap initially determined?

The market cap of a company is first established before its initial public offering (IPO), whereby an investment bank employ valuation techniques to derive a company’s value and determine the price and amount of shares to be offered.

Following the IPO, the company will be traded on the exchange, and its share price will now be determined by supply and demand in the market.

Favourable company or industry factors could increase share demand, which will increase the price. Whereas if the company’s future growth potential does not look good, investors choosing to sell their stock could drive down price.

Therefore, the market cap becomes a real-time estimate of the company’s value.

Using market cap in your investment strategy

As the market cap is a simple and effective means of risk assessment, it can be a helpful metric for investors in determining which stocks you are interested in, and how to best diversify the sizes of the companies within your portfolio.

There are four categorisations for market capitalisation based on size: large-cap, mid-cap, small-cap and micro-cap.

Large-cap companies have a market cap of $10 billion or more. Such companies are generally more mature, well-known companies within established industries. Whilst investing in large-cap companies doesn’t necessarily yield huge short term returns, long term investors are usually rewarded with consistent increase in share value and dividend payments.

Examples of large-cap companies include the $206.3BN capped BHP Group (ASX: BPH), the $63.7BN capped Wesfarmers Limited (ASX: WOW) and the $157.5BN capped Commonwealth Bank of Australia (ASX: CBA).

Companies with a market cap between $2 billion and $10 billion are generally Mid-cap companies. These are well established companies that operate in industries which are emerging and forecasting rapid growth. As mid-caps are in the process of expanding, they carry higher risk than large-caps who are inherently more established, but this growth potential is often appealing for investors.

Mid-cap companies on the ASX include the $10.7BN capped SEEK (ASX: SEK) and the $7.6BN capped A2 Milk Company (ASX: A2M).

Small-cap companies are commonly classified as having a market cap of between $300 million to $2 billion. These tend to be young companies that serve emerging industries or niche markets, and as such, are considered higher risk investments. Small caps generally have fewer resources are more sensitive to economic slowdowns and market volatility, and less liquid than more mature and larger companies.

Nonetheless, these companies often provide greater growth opportunities than large-caps.

An example of a small-cap company is the $807.6M capped Vulcan Energy (ASX: VUL).

Even smaller companies are known as micro-cap, possessing values up to $300 million and include WhiteHawk Ltd (ASX: WHK) at $80.8M, Elixir Energy (ASX: EXR) at $133.8M and EuroManganese (ASX: EMN) at $218.9M.

How to build your market cap portfolio preference

As market capitalisation is more-or-less commensurate with a company’s stage of business development, the decision to invest in a micro-cap, mid-cap, or large-cap corresponds roughly to investors’ risk/reward profiles.

Choosing to invest in a large-cap stock is often considered more conservative than investing in a smaller valuation company. While the early stage and limited resources of small-caps increases companies’ exposure to business or economic downturn, significant growth potential is offered to long term investors who can tolerate volatile stock price swings in the short term.

A common method to gauge the performance of an investment is to measure its returns against those of an index containing similar investments.

In Australia, the S&P/ASX 50 contains the 50 largest companies on the Australian stock market, and the S&P/ASX Mid Cap 50 is comprised of the members of the S&P/ASX 100, excluding those in the S&P/ASX 50.

Small caps sit outside of the largest 100 on the ASX, and the benchmark for small cap Australian shares is the S&P/ASX Small Ordinaries index (XSO), which represents the smaller members of the S&P/ASX300 index.

Always best to diversify

As each market capitalisation category can be affected differently by economic or market developments, over time, large-cap, mid-cap, and small-cap stocks have taken turns leading the market.

Indeed, when large-caps are declining in value, small-caps or mid-caps may be on the way up and could potentially help counteract any losses.

Therefore, it is strongly advised that investors diversify; sustaining a mix of market caps in their portfolios to reduce investment risk in any one area, and support the pursuit of one’s long-term financial goals.

It is best to seek professional financial advice to help you meet these goals.

Things to keep in mind

Although market cap is used abundantly to describe a company, only through a thorough analysis of a company’s fundamentals can one properly measure the equity value of a company.

Remember, the market price determining the capitalisation doesn’t necessarily reflect how much a piece of the business is actually worth, leading companies to often be over or undervalued – as this is only based upon how much the market is actually willing to pay for its shares.