What is Market Cap?Sep 29, 2020
Welcome to the second article on “Introduction to the Stock Market”. In this article, we will be covering Market Capitalization or Market Cap for short.
According to Investopedia, Market capitalization refers to the total dollar market value of a company's outstanding shares of stock. Commonly referred to as "market cap," it is calculated by multiplying the total number of a company's outstanding shares by the current market price of one share.
On the surface, the market cap looks really unimportant. Below the surface, your investing (trading) style and the market cap are tightly related. To prove that, let’s proceed with a question.
What kind of investor are you?
Are you a short term or long term investor?
To make it easier for you to answer, let’s take a look at the different market cap ranges.
As you can see from the diagram, the market cap divides to 5 sub categories, which are:
- Micro-cap: below $250 million
- Small-cap: $250 million to $2 billion
- Medium-cap: $2 billion to $10 billion
- Large-cap: $10 billion to $100 billion
- Mega-cap: above $200 billion
If you’re a short term investor like the majority of retail traders trying to scalp stocks, you’d be better off gambling in a casino. Why is that? As retail traders, we don’t have access to huge capital. To compensate for the lack of capital, retail traders will stick to low market cap stocks.
Besides the ranges that we described above, what exactly is a market cap? The market cap represents the total value of all outstanding shares of a company.
In the last article we talked about Tesla as our example company. Here we will use it again. Tesla’s total outstanding shares are 931,810,000, while the current market cap is $395,290,000,000. To calculate the price per share we need to divide the current market cap to the total outstanding shares. After we do the calculation, the price per share is $420.998.
Now that you understand market cap, I hope you realize why we as retail traders have to stick to small market-cap stocks. Of course big tech giants like Apple, Google, Amazon, Tesla are way better investments, but to make serious profits owning these companies you would need huge capital. Most people would say “I prefer those expensive stocks, because they’re safer”. As always the truth is somewhere in the middle between the right and wrong. Yes they are safer, but let’s say you own 5 shares of Tesla, which we calculated above at $420.998 per share, you would need to invest $2104.99 in those shares.
If the price per share increases by $100, you would earn $500 which is actually a 1:4 risk to reward ratio. But what are the chances that the stock will increase in price so much in a short period of time? Unless something extraordinary happens, you won’t see any stock growing that fast.
If that $100 increase in the share price takes 12 months, would it be worth it to lock your capital up for a year and earn 25% of your investment? The answer is up to you. If you’re satisfied with the 25% return of your capital, the answer would be “yes”. If you want to grow your capital faster, while seeking bigger returns, the answer would be “no”, which leads us to the small market-cap stocks.
With our limited capital, the small market-cap stocks would produce bigger returns, because you would own more shares, therefore you would compound more from the bigger quantity of shares. Also, small market-cap stocks tend to be more volatile than the giants. All these positive perks, come at a price.
With small market cap stocks, all you have is speculation. Out of a sudden, positive developments come out for company X leading to a surge in price. Then some investors compound their gains, while others wait for a bigger profit, but instead, the price reverses fast, and then they end up losing a moderate percentage of their capital.
All of this is very common because the majority of small market cap trading is done by retail traders. You would not see any big investors in this value range unless they see a good opportunity for future growth.
Unlike short-term investors, long-term investors look at the fundamentals behind a company. Important fundamentals a long term investor must know are financial statements released by a company, profitability, liquidity, utilization of income, and many more parameters, which draw the complete picture of a company. In small market-cap companies, those fundamentals are close to non-existent which means you are no longer investing, instead you’re gambling (kinda).
I hope now you see why the market cap is tightly related to your investing (trading) style. You can’t expect most small market cap stocks to be safe investments while seeking bigger returns and operating with limited capital.
Everything inside this article should be more than enough to show you the path and the obstacles you will face no matter which path you take.
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