Are you one of those individuals who is newly entering the trading world?
Are you interested in expanding your knowledge spectra when it comes to trading?
Then this two part series is surely suitable for you. Here, you can learn about one of the fundamentals of trading that is, 'Market Capitalization'.
Market Capitalization
The
term “market capitalization,” commonly referred to as “market cap,” is one of
those financial words that gets thrown faster than a hot potato, but investors
need to know what it means and what it doesn't mean. Once clearly defined, the
question is: how important is market capitalization?
The
formal definition of market capitalization is the value of a publicly-traded company,
calculated by the total number of shares multiplied by the current share price.
For example, a company with 10 million outstanding shares selling for $ 100
each would have a market capitalization of $ 1 billion.
Thus,
a company can increase its market capitalization by increasing the share price
or by issuing more shares (without diluting the market price). Note that to
calculate the true market capitalization of a company, the total value of all
outstanding bonds must also be included.
Large Caps, Mid-Caps and Small Caps
Large
capitalization, also known as large caps are considered those that have a
market capitalization of $ 10 billion or more. The most common representations
of this category would include the Dow Jones Industrial Average, often called
“the Dow,” which is a price-weighted index comprising 30 leaders in the
economy.
The
SP500 index is the other main representation of blue-chips, taking into account
the real market capitalization and in which many more companies participate, approximately
500, but not always exactly 500.
At
the other end , small caps stocks are basically valued between $ 300 million
and $ 2 billion. Small-cap stocks are typically measured by the Russell 2000,
which is the 2,000 smallest companies in the Russell 3000 index. All companies
that fall within that $ 2 billion to $ 10 billion range are conveniently called
mid-cap stocks.
Many
investors equate these capitalization figures with the risk profile of a
company, thinking that large caps are naturally stronger than small ones. This
is not always true.
Statistics
Apple is a great example, Steve Jobs and Steve Wozniak launched Apple's IPO (Initial Public Offering) in 1980 at $ 22 per share for a market capitalization of $ 1.8 billion, a small capitalization by current metrics.
In 2020, Apple's market
capitalization surpassed the absolute value of the whole Russell 2000 and today
it has a market capitalization of over $ 2.27 trillion.
Small-cap
stocks are not always necessarily start-ups and can be well-targeted
organizations on their way to the large-cap category. On the contrary,
sometimes the bigger they are, the harder they fall.
In
2001, Enron was the seventh-largest company in the world, with a market
capitalization of $ 65 billion; In the span of four months of scandal, its
stock price went from $ 90.75 to $ 0.26 before its eventual bankruptcy.
According
to the observations made, small-cap stocks returned an average of 12.1% per
year between 1926 and 2017, while large-cap stocks returned 10.2% in the same
period. Small caps are more popular than ever, as within a month into the 2021,
small caps have returned 16.75%.
Essential Points to Note
You
should never forget that these are averages, and that averages can differ
drastically based on the snapshot an investor invests in. Throughout history,
small caps have been more volatile than large caps, meaning that a shorter
investment horizon would likely have produced significantly higher or markedly
lower returns than large caps, less volatile.
Small-cap
companies tend to offer greater growth potential than larger companies. Just
like, McDonald’s is unlikely to double in size in a year, but they may be more
susceptible to market fluctuations as they have less access to capital than the
giants.
Investors
should understand that market value or market capitalization is very different
from book value. The book value is the real value of the company according to
its financial statements.
In
theory, book value is what investors would receive if the company sold all of
its assets and paid off its debts. Market values change rapidly from day to day based on the stock market.
Warren
Buffett is a famous value investor who has always sought to buy companies with
a market value below their book value. This has suffered for the last decade or
so, as large-cap companies in the tech space have continued to spike well above
their book values.
Hopefully,
this provides a clearer understanding of market capitalization and how it can
be used as an indicator to build an investor's portfolio asset allocation.
Always remember that past performance cannot guarantee future performance.
So,
have a better understanding of the things and research, read, study more in
order to increase your knowledge.
Written
By - Sanskriti Dimri
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