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When we talk about the size of a company, we rarely use the number of employees or the revenue as a metric, we use market capitalization, or market cap for short.
The market cap offers a standard way to assess the overall value of a company as identified by the price investors are willing to pay. It’s very different from the intrinsic value of a company on paper.
This is why, during a recession, some companies can lose as much as 25% or 50% in market cap while the assets for the company stay the same. It’s a simple consequence of using the price as part of the calculation.
Market cap only reflects a company’s market value, not its debts or liabilities. As such, market cap will always be positive. By determining a company’s size, investors can identify the type or research needed as well as the type of growth expected.
What Is Market Cap?
In simple term, it’s the company value given by investors. The formula is simple and is the number of outstanding shares multiplied by the stock price.
Market Cap = # Shares x Stock Price
For example, if a company has 1,000,000 shares outstanding and trades at a $100 price, the company has a $100 million market cap.
When news outlet discuss the size of a company, market capitalization is the financial metric used to do so.
If you search for the largest company in the world, you simply find the largest company by market capitalization. These days, the largest company in the world is Apple.
Breaking Down Market Cap Into Tiers
As an investor, it’s easier to research companies by grouping them.
For example, does it matter if Company A has a market cap of $120B versus Company B has a market cap of $140B? Not really since they are both close from a number perspective.
However, if you compare Company A with Company C where it has a market cap of $40B, then you are not comparing the same even if all the companies are in the same sector and industry.
The business life cycle of a business can also be mapped by its market cap. The size of business maturity are related. Therefore, investment growth in the company as well as investment risk can also be inferred from their market cap.
Business Life Cycle
- Start-up: A new launching new products or services. Rarely do they trade on the stock market. Still proving themselves ahead of an IPO.
- Growth: Successful launch and growing. Usually with rapid sales growth. Looking at an IPO and turning a profit.
- Established: Sales are slowing down from competition or saturation.
- Maturity: Sales are normalizing and profit margins are getting thinner.
- Expension/Decline: This is an adapt or fail turning point. Larger companies will have products go through the cycle internally at faster rate.
Market Cap Tiers
- Mega Cap: These companies dominate their industry and often have very little competition. Their challenges are often around becoming too much of a monopoly and regulators stepping in.
- Large Cap: These companies are very mature and usually have a moat. There is competition but it is limited to a small number of companies.
- Mid Cap: These companies have grown and are focused on dominating their business. At this level, you get a higher level of safety compared to the smaller companies.
- Small Cap: These companies are in the growth business life cycle and have potential to grow more or be acquired. There are still risks and your money could go sideways at times but you could have higher returns.
- Micro Cap: These companie have usually struggle to grow at the expected pace. Still in the start-up phase to some extent working to get in the growth phase. There is potential but it’s also risky.
- Nano Cap: These companies fall into the penny stocks category. These companies have the highest risk with the potential for some high reward.
Now, there are always exceptions to the rule.
What Does Market Cap Tell You?
Generally speaking, the market cap can help you establish which stage of business the company is in.
It’s not a slam dunk as some high flying technology companies do not always follow the pattern when there is significant growth in a new market.
I like to invest in mega cap and large cap stocks that dominate their industry. You can see from my portfolio where I hold mostly large cap blue-chip stocks from both the TSX and mega cap stocks from the US.
A dominant large cap stock will have less chances of being disrupted by competitors and the competitors are usually known. Now, too much of a large cap without innovation can limit your returns but it can let you sleep at night.
I use the very safe large cap as my foundation and then the other growing large cap for more growth. It’s worth noting that I don’t breakdown my portfolio by market cap but rather by yield and dividend growth.
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