Investing Basics: small, mid, large cap - does size matter?
An understanding of market capitalisation and its use in valuing, comparing and categorising stocks may help you build a diversified investment portfolio.
Earlier this month American tech giant Apple became the first publicly listed company to be valued at more than $1 trillion.
In a memo to staff, Apple chief executive Tim Cook understated things somewhat by describing the feat as a "significant milestone" that gave the company "much to be proud of."
But what does this record valuation actually mean in the minds of ordinary investors? Is Apple – its brand, physical assets and cash on hand – valued at $1 trillion? Or is $1 trillion a value the stock market is attributing to Apple's stocks?
In this instalment of Investing Basics, we explore how investors use market capitalisation to value, compare, and categorise stocks, and why an understanding of this may help you build a diversified investment portfolio.
What is market capitalisation?
Market capitalisation – or “market cap” – is investment jargon for a straightforward concept.
Market capitalisation is the value of a company's outstanding stocks – outstanding shares are issued shares owned by stockholders.
Market cap is calculated by multiplying the number of a company's shares outstanding by its price per share.
Stock price capitalisation = total number of shares outstanding x the current stock price
For example, the Commonwealth Bank (ASX: CBA) has a current share price of $73.23 and 1.76 billion shares in circulation. That means its market cap is about $128 billion.
Investors use this calculation to determine a company's size relative to another. It also helps investors determine a company's value and a fair price for its shares.
It's important to note that market cap will not tell you what the underlying business is worth. Rather, it gives you a sense of how the market values the company, so tread carefully.
Defining large, mid- and small-cap stocks
The Australian Securities Exchange has more than 2,000 companies listed, ranging from multinational mining conglomerates to small producers of Australian honey. Investors use market capitalisation to divide listed stocks into three broad categories according to size: large market cap, mid market cap and small market cap.
Large caps: these are the biggest companies on the ASX by market cap. They represent more than half of the Australian share market by market cap. The market cap of these securities is typically over $10 billion. Investors may also refer to these stocks as “blue chips” – meaning stocks of strong, well-established companies that have demonstrated their ability to pay dividends in both good and bad markets.
Mid caps: these are next biggest set of companies on the ASX by market cap. The market cap of these securities is between $2 billion and $10 billion.
Small caps: these companies typically sit outside of the top 100 listed companies by market cap. The market cap of these securities is between $100 million and $2 billion.
Note that the thresholds between two categories won't be the same in all markets. A company that's considered mid-cap in Canada would probably land in the small-cap category in the US, for example.
The Morningstar stock screener can help you find stocks above or below a specific market capitalisation.
Why you should pay attention to market cap
Spreading your holdings among stocks of different capitalisation levels is a good way to get diversification in your portfolio, since small caps and large caps typically present different growth and risk profiles. Large caps are usually less risky, but their growth potential is somewhat limited, whereas small caps give you the opportunity to get super-sized growth, but you may be in for a bumpy ride.
Market capitalisation can also help you determine which types of strategies to pursue for different types for stocks. For instance, Morningstar analyst Anshula Venkataraman writes of the Vanguard MSCI Australian Small Coms ETF (VSO) – an ETF which tracks the returns of the Australian Shares Small Cap Index – that in the current market active managers have an edge.
"Unlike index-trackers, we think active managers have more opportunity to capitalise on informational advantages in this under-researched space, and to avoid the smallest, most speculative, and unprofitable companies,” Venkataraman says.
Lastly, depending on what type of investor you are, you may want to avoid certain types of companies.
If you're an income investor – attempting to generate a steady income via dividend-paying stocks – it's important to use market capitalisation to evaluate a stock, as large caps are usually associated with stable companies that regularly pay dividends, while small caps generally pay no dividends.
More in this series
• Investing Basics: Everything you need to know about reporting season
• Investing Basics: How do your savings compare to those of your peers?
Emma Rapaport is a reporter for Morningstar Australia.
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