The market capitalization, or “market cap,” is the value of a company’s publicly traded shares multiplied by its current share price. According to their market caps, companies are classified as small-cap, mid-cap, and large-cap, with each category presenting varying levels of risk and growth potential.
The market cap of a company does not directly affect the stock price of the company, but it indirectly affects it through investor perception, analyst attention, and index inclusion. The negative aspects of this system are that it is susceptible to market fluctuations, fails to reflect debt, and is manipulated.
The market cap remains a crucial metric for investors despite its limitations because it allows quick evaluation of company size, facilitates portfolio diversification, facilitates company comparisons, and plays an important role in mergers and acquisitions.
If you’re working on an investing plan to help you reach long-term financial objectives, you need to understand the link between business size, return potential, and risk.
With this understanding, you’ll be better able to create a balanced stock portfolio that includes a variety of “market caps.”
What Is Market Capitalization?
Market capitalization, commonly referred to as “market cap,” is the total financial value of all of a company’s publicly traded shares of stock.
For example, if a company has 10 million shares outstanding and each share is currently trading at ₹4,000, its market capitalization would be ₹40,000 million (10 million shares * ₹4,000/share), or ₹4,000 crore.
How Market Cap is Calculated?
We use the following formula to calculate market capitalization:
Market Capitalization = Current Share Price * Total Number of Outstanding Shares
- Current Share Price: The real-time price at which the company’s stock is trading on the stock exchange.
- Total Number of Outstanding Shares: This refers to the total number of shares issued by a company and currently held by investors. This includes shares held by the public, company insiders, and institutional investors.
For example:
Let’s say Company XYZ has 20 million outstanding shares, and its current share price is ₹5,000 per share.
To calculate its market capitalization:
Market Capitalization = ₹5,000/share * 20 million shares Market Capitalization = ₹100,000 million, or ₹10,000 crore.
What Are the Three Main Categories of Market Cap?
According to this common method of analyzing a company, an investor can pick between three kinds of stocks. Balancing the portfolio with a balanced combination of all of these decreases the risk potential.
| Type of Stock | Market Cap Range |
|---|---|
| Small-Cap Stocks | Up to Rs. 500 crore |
| Mid-Cap Stocks | From Rs. 500 crore up to Rs. 7,000 crore |
| Large-Cap Stocks | From Rs. 7,000 crore up to Rs. 20,000 crore |
Mega-Cap stocks are companies with a market capitalization (MC) of more than Rs. 20,000 crore. We delve deeper into the three basic categories of shares that investors choose to invest in below.
Small-Cap
Companies with the lowest market capitalization are the most risky of all equities. These represent new companies that have yet to establish themselves in their respective industries.
This makes them very dangerous. Success may explode its stock price, while failure might result in major losses for its stockholders. These are the most aggressive investing possibilities.
Mid-Cap
Companies that have had some growth and are fairly constant but still have enormous growth potential are classified as market capitalization-based. These stocks show that the business has made a name in its field, with the potential for future development.
These new companies are risky to invest in, but their stocks are safer than those of the following companies. As a result, they may outperform large-cap equities in terms of returns.
Large-Cap
These are likely the most stable groups of businesses on the market. As a result, investing in these businesses is the lowest-risk choice. Another vital factor to consider is that while they are solid enterprises, their returns are very low.
Typically, these businesses reached the height of their growth, so there is less probability of a major shift in stock prices. However, the low risk and less aggressive growth make investing in these equities a safe choice.
How Does Market Cap Affect Stock Price?
The market cap of a company has no direct impact on its stock price. The relationship works as follows:
- The Core Relationship: The market capitalization of a company is determined by its stock price, not by its cause. The market cap is calculated by multiplying the current share price by the number of outstanding shares. If the share price increases, the market cap will increase, and vice versa.
- Indirect Influences: Stock prices can be indirectly affected by market capitalization even though it does not directly affect them.
- Investor Perception: Market capitalization signals to investors that a company is well-established and trusted. Stock prices may rise as a result of this increased demand.
- Analyst Attention: A large-cap company is typically given more attention by financial institutions and experts than a small company.Stock prices can increase when analyst reports are positive and affect investor mood.
- Index Inclusion: Large-cap stocks regularly appear in major stock indexes. When a company is added to an index, index funds purchase its shares, increasing demand and possibly influencing prices.
Things to Keep in Mind:
- Market cap is not the sole determiner. Market conditions, earnings reports, and company news all affect a company’s stock price in the end.
- Focus on fundamentals: A company’s market cap does not tell you everything about its performance or intrinsic value. Financial ratios and fundamentals should also be considered by investors.
What Are the Limitations of Market Cap?
While market capitalization is a useful metric, it’s important to understand its limitations:
- Market Perception vs. Intrinsic Value: Market capitalization represents the market’s current valuation of a company’s worth, which may not constantly match its true intrinsic value. Excitement, theories, and the overall market mood can affect stock prices, potentially leading to overpriced or undervalued businesses.
- Vulnerability to Fluctuations: Stock prices are naturally volatile, particularly in the short term. The market capitalization undergoes regular changes due to its close relationship with the stock price. This may not reflect changes in the company’s fundamental business performance.
- Doesn’t Reflect Debt: Market capitalization simply looks at the value of the equity of a business. It does not take into account a company’s debt. An indebted business may yet have a high market capitalization, hiding its true risk of failure.
- Comparability Across Industries: Comparing market capitalizations across industries might be false. Some sectors are naturally more valuable than others. A technological business may have much smaller market capitalization than a mature utility company, but it is a more attractive investment.
- Manipulation: It is possible to manipulate market capitalization in some situations. For example, a company may issue a significant number of new shares, raising its market capitalization without affecting its fundamental business.
How to Address Limitations?
- Focus on Fundamentals: Make financial decisions based on more than just market capitalization. Review a company’s financials, profits, and growth prospects thoroughly.
- Use Valuation Ratios: To better understand a company’s valuation, combine market cap with other financial ratios such as price-to-earnings (P/E) and price-to-book (P/B).
- Consider Industry Context: It is best to compare companies within the same industry since valuations vary by industry.
If you want to read more articles related to the share market, you can also read these articles by clicking the links given below:
- What Is a Common Size Financial Statement? A Beginner’s Guide to Understanding Financial Data
- What is Discounted Cash Flow (DCF)? A Simple Explanation for Investors
Why Market Capitalisation is Important?
The market capitalization of a company provides investors with valuable insight into its size, risk profile, and investment potential. A size indicator is used to categorize businesses as large, mid, or small.
The market power of larger companies typically reflects their resources, market influence, and brand recognition. Market cap is also useful for assessing investment risks, as large-cap companies are often considered more stable and less susceptible to volatile price swings.
As an investment strategy, market capitalization enables investors to balance risk and reward by including companies of different sizes. Large-cap stocks are also frequently included in major indices, which impacts index-tracking funds.
Using market capitalization when comparing companies of similar sizes within the same industry allows investors to make more informed decisions about performance metrics and financial health. As a final point, market capitalization plays a crucial role in mergers and acquisitions, helping acquirers assess a target company’s fair value and assessing the costs of acquisition.
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