We explain what market capitalisation is by looking at large, medium and smaller company stocks and how similarly sized firms behave in similar ways to influence investor returns.
Market capitalisation definitions and thresholds
Market capitalisation (market cap) is a rough indicator of the worth of a company.
Calculate market cap: share price times the number of shares outstanding.
Example: Microsoft has 7.57 billion outstanding shares at a share price of $242:
7.57 billion x 242 = $1.62 trillion
In the UK stock market the FTSE 100 index – the top 100 largest publilcy listed companies by market capitalisation – consists of large capitalisation stocks.
The FTSE 250 index of the 101st largest to the 350th, contains medium capitalisation (mid caps) stocks.
The smallest capitalisation stocks are listed on the FTSE Small Cap, FTSE Techmark 100 and the Alternative Investment Market (AIM).
Market cap sizes
Large caps are usually defined those above $10 billion, mid cap $2 billion to $10 billion and small cap below $2 billion. The threshold for small caps can also be drawn at $1 billion.
The most valuable company in the world, Apple, has a market capitalisation (market cap) at the time of writing of nearly $2 trillion.
Marketcap is a measure of size not performance
Market capitalisation reveals to the investor nothing about how a company is performing – only its total value in capital terms.
A company can have a large capitalisation but currently be unprofitable, such as British Airlines owner International Consolidated Airlines Group (IAG) in second quarter 2020.
Capitalisation bestows certain investment characteristics on company behaviour and performance.
Large cap (large capitalisation) stocks will be highly liquid with plentiful trading volumes and an array of analysts covering the companies on behalf of brokerage and investment firm clients.
Many large cap tech stocks are also on the radar of global investors.
Liquidity and volatility
Liquidity is a measure of how easy it is to buy and sell shares in a particuar market.
Dealing in small capitalisation (small caps) stocks that lack the liquidity of large caps makes it harder to fill buy and sell orders. Because of that, the spread between the bid and offer (buy and sell) price can tend to be wider and prices may not move as often, but when they do it can be by significant amounts.
Higher volatility and lower liquidity, therefore, tend to be characteristics of small cap stocks, while lower volatility and higher liquidity characterise large caps.
Large caps – the larger of which are sometimes referred to as ‘Mega Caps’ – will tend to have more international sales.
For example, when the pound falls against the dollar it makes FTSE 100 companies that book their profits in the US currency wealthier.
Take BP – it coverts its dollar revenues from oil sales into pounds when it brings the money home, and gets more pounds for its dollars. A fall in the pound against the dollar (GBP/USD) will magnify the dollar earnings and therefore push up share prices and the FTSE 100 index as a whole.
The diversity of earnings that a large cap can generate are a further area of corporate strength.
Medium capitalisation (mid caps) stocks will be found across all industrial categories and sectors.
Stocks in this band will have deeper pockets for investment and reserves than small caps but also may have the adeptness and nimbleness lacked by large caps to reorganise for new opportunities.
Perhaps the most salient difference in the properties of large and small cap is in the growth department.
In the three years to 1 January 2020 the FTSE 250 rose 37% compared to 18% for the large cap FTSE 100.
Small caps hold out the prospect of much better risk-return profiles. A £100 investment (risk) could return £1,000 in a small cap but this is much less likely to be the case with a large cap stock of an established company, which is what a large cap is likely to be.
Small caps have the headroom to grow, but large caps have the reserves to weather the storms. This gives them a big edge in periods of slowing economic activity compared with small caps.
Strong performers in upturns
Small caps perform more strongly than large caps in a recovery. This is because they tend to be in cyclical industries such as retail, hospitality and other services sensitive to the ups and downs of business activity.
They are also more focused on the domestic economy.
Small caps are also more often than not likely to be losers, although there is a wide risk gamut of small caps to choose from.
There are a multitude of reasons for business failure of new concerns. A company despite a promising start fails to gain traction for its product or service, or after a few years of striving towards profitability fails – busniess failure is part of the risk of investing in small caps.
For small cap investors there’s a world of difference between a penny stock of a company with non-existent revenues and an AIM-listed small cap that has been trading profitably for five years. In the former, an investor could lose all their capital.
Small caps includes the smallest of companies but these ‘penny shares’ are low liquidity and high volatility and might be better placed in a micro-cap category ($50 million to $300 million).
Track index promotions and relegations
Index rebalancing by market cap takes place quarterly for most stock market indices. As companies grow and shrink in value, their index membership changes accordingly.
Promotion and relegation from major indices is a significant event for a stock.
Promotion to the FTSE 100, for example, woud lead to an immediate boost in buying because of the tracker funds that mirror the index would have to buy the shares of the new constituent. The same goes for pension funds that will often track the FTSE 100.
Trading the news
Share prices can move in expectation of a promotion or demotion from a major index.
By market cap, Tesla was in line to join the S&P 500 and the prospect is thought to have helped an acceleration in its share price in late August 2020.
Those running the indices and policing the methodologies need to be sure as they can that a stock recently added as a constituent can be expected to stay in the index for a reasonable period. Because of this, market capitalisation is the major – but not only – consideration when indices rebalance to account for changes in constituent members’ share prices.
In September 2020 Telsa by market cap alone should have been promoted to the S&P 500. The price rose partly in expectation of index entry but when the S&P 500 was rebalanced Tesla was left out, despite its market cap qualification.