InvestorQ : Can you explain the concept of market capitalization and why is it useful for an investor from an analytical perspective?
Arti Chavan made post

Can you explain the concept of market capitalization and why is it useful for an investor from an analytical perspective?

Answer
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1 year ago


Market cap—or market capitalization—refers to the total value of all a company's shares of stock. It is calculated by multiplying the price of a stock by its total number of outstanding shares. For example, a company with 20 million shares selling at Rs.50 a share would have a market cap of Rs.1 billion. Why is market capitalization such an important concept? It allows investors to understand the relative size of one company versus another. Market cap measures what a company is worth on the open market, as well as the market's perception of its future prospects, because it reflects what investors are willing to pay for its stock.

Large-cap companies are typically firms with a market value of Rs.10 billion or more. Large-cap firms often have a reputation for producing quality goods and services, a history of consistent dividend payments, and steady growth. They are often dominant players within established industries, and their brand names may be familiar to a national consumer audience. As a result, investments in large-cap stocks may be considered more conservative than investments in small-cap or mid-cap stocks, potentially posing less risk in exchange for less aggressive growth potential. Mid-cap companies are typically businesses with a market value between Rs.2 billion and Rs.10 billion. Typically, these are established companies in industries experiencing or expected to experience rapid growth. These medium-sized companies may be in the process of increasing market share and improving overall competitiveness. This stage of growth is likely to determine whether a company eventually lives up to its full potential. Mid-cap stocks generally fall between large caps and small caps on the risk/return spectrum. Mid-caps may offer more growth potential than large caps, and possibly less risk than small caps. Small-cap companies are typically those with a market value of Rs.300 million to Rs.2 billion. Generally, these are young companies that serve niche markets or emerging industries. Small caps are considered the most aggressive and risky of the 3 categories. The relatively limited resources of small companies can potentially make them more susceptible to a business or economic downturn. They may also be vulnerable to the intense competition and uncertainties characteristic of untried, burgeoning markets. On the other hand, small-cap stocks may offer significant growth potential to long-term investors who can tolerate volatile stock price swings in the short term.

Market cap versus free float market cap: what is the difference?

Market cap is based on the total value of all a company's shares of stock. Float is the number of outstanding shares for trading by the general public. The free-float method of calculating market cap excludes locked-in shares, such as those held by company executives and governments. Free-float methodology has been adopted by most of the world’s major indexes, including the Dow Jones Industrial Average and the S&P 500. In India, both the principal indices viz. Nifty and the Sensex are free float based market related indices. This makes them more representative as they are based on public shareholding. So what are the factors that actually impact the market cap of a company?

There are several factors that could impact a company's market cap. Significant changes in the value of the shares—either up or down—could impact it, as could changes in the number of shares issued. Any exercise of warrants on a company's stock will increase the number of outstanding shares, thereby diluting its existing value. As the exercise of the warrants is typically done below the market price of the shares, it could potentially impact the company's market cap.

But market cap typically is not altered as the result of a stock split or a dividend. After a split, the stock price will be reduced since the number of shares outstanding has increased. For example, in a 2-for-1 split, the share price will be halved. Although the number of outstanding shares and the stock price change, a company's market cap remains constant. The same applies for a dividend. If a company issues a dividend—thus increasing the number of shares held—its price usually drops.

To build a portfolio with a proper mix of small-cap, mid-cap, and large-cap stocks, you'll need to evaluate your financial goals, risk tolerance, and time horizon. A diversified portfolio that contains a variety of market caps may help reduce investment risk in any one area and support the pursuit of your long-term financial goals.