The term market capitalisation is used frequently in the financial media. In this article we discuss what this means and the importance of market capitalisation when analysing a company.
Market capitalisation is calculated by the number of shares outstanding multiplied by the market price of one share. It simply reflects the total dollar amount of all the outstanding shares of a company at the market price.
Market Capitalization = number of shares outstanding * market price of one share
Why is market capitalization important?
Companies can be segregated into small, mid, and large capitalization. This can help identify different factors such as how risky the stock is, whether the company will provide dividends, and the liquidity of the stock.
A large cap stock is classified as a company which has a market capitalisation of more than $10 billion. Large cap or blue-chip stocks are the largest companies on the Australian stock exchange. These companies have generally been around for a long time and are considered stable companies. They usually offer a dividend as their businesses are well established and have consistent cash flows. They are considered less risky and have high liquidity. They have less volatility in their stock price. These companies are mature businesses, so these stocks do not experience as much capital growth as small caps.
Mid cap stocks have a market cap ranging from $2 billion to $10 billion. These stocks are expected to generate rapid growth. These companies offer a hybrid of growth and stability. They can offer more capital upside than large cap stocks but are considered less risky than small cap stocks. Mid cap firms historically grow their earnings faster than small and large cap firms. As these businesses are established, investors will see less capital appreciation in these stocks compared to small caps. These firms are not as stable as large cap firms as they do not have as much capital.
Small cap stocks are usually companies that are younger. They are generally looking to grow their businesses at an accelerated rate. Small cap companies have a market cap between $300 million and $2 billion and are often categorised as growth stocks. These are business in the growth phase so there is higher potential for capital growth. Small cap companies are usually domestically focused so they are less affected by conflicts in international trade. These firms are not as stable as large cap firms as they do not have as much cash. As these businesses are in the growth phase, they may reinvest funds from earnings and not pay dividends to investors. There is also less liquidity in the stock market for small caps. Share prices of small cap stocks experience high volatility. This could lead to stock prices falling harder in bear markets. There is more risk in investing in small caps as companies are newer and are less established businesses. Small cap stocks are also reliant on external capital as their capital is limited. There is a higher chance of bankruptcy with small cap stocks than larger cap stocks.
Lauren Hua is a private client adviser at Fairmont Equities.
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