Using Market Capitalisation for Better Investment Decisions

Summary:

Market capitalisation, also called 'market cap', is a metric in the financial world that is used to calculate the total size or value of a publicly traded company. It is the full market value of the equity or ownership of a company. This blog has all the details.

Introduction to market capitalisation

Market capitalisation, also called 'market cap', is a metric in the financial world that is used to calculate the total size or value of a publicly traded company. The calculation is done by multiplying the current stock price of the company by the total number of outstanding shares of its stock. Put simply, it is the full market value of the equity or ownership of a company. 

Components of market capitalisation: 

The following are the components of market capitalisation and their breakdown:

• Stock price per share: The existing trading price of each share of the stock of the company on the open market is known as the stock price of each share. This price can vary during the trading day, because of which the market cap will change as well.
• Total outstanding shares: This refers to the total number of shares of the organisation's stock which have been issued and can be traded on the stock exchange. This includes shares held by both institutional and individual investors. 

Market capitalisation keeps fluctuating daily because of changes in the number of outstanding shares and stock prices. The reason why it is important in the world of finance is because it is used to segregate firms into different size classes: small-cap, mid-cap and large-cap. This provides analysts and investors with details about the condition of the market and the performance of companies and their size. 

The market caps for individual companies and the market as a whole can change swiftly because of trends and economic factors. Despite this, it is a crucial metric that investors use for making informed decisions.

Calculating market capitalisation:

To calculate market capitalisation, the formula is:

Market capitalisation = total outstanding shares x stock price of each share

Example: If a firm has a stock price of INR 50 and there are 1 Lakh outstanding shares, the market capitalisation would be:

Market cap = INR 50 × 1,00,000 = INR 50,00,000

Hence, the market capitalisation of the firm, in this case, would be INR 50 Lakh.

How investors use information about market cap:

Market cap is a crucial metric which provides investors with vital information about a firm's size and its position in the financial markets. The following are some of the ways market cap assists to make informed investment decisions: 

• Risk and size: Market cap is used to segregate companies into size groups. These are small-cap, mid-cap and large-cap. This helps traders evaluate the risks associated with putting their money in a specific company. Usually, larger-cap organisations are said to be less risky than smaller-cap firms. Despite the risks, smaller-cap firms have growth potential, which means they may be able to give high returns in the future.
• Investment strategy: Investors rely on information about market cap to align their investment strategies with their goals. For example, traders with a conservative way of looking at things choose to invest in large-cap companies. This is because they are usually less volatile and more stable. In comparison, those who want higher returns turn their attention towards small and/or mid-cap companies.
• Diversification: Investors frequently diversify their portfolios using market cap. By investing in firms of different market cap sizes, they are able to spread the risk and mitigate the impact of adverse events that would affect a single stock or sector.
• Analysis of performance: Market cap is used for comparing the performance of various companies and/or stocks within the same industry. Traders monitor the performance of small-cap, mid-cap and large-cap indices to identify trends and make decisions about investments.
• Liquidity considerations: The market cap of a company affects liquidity. Stocks of large-cap companies usually have greater trading volumes, and the bid-ask spreads are narrower. This makes it easy for traders to purchase and sell shares without having any significant impact on the price of the stock. Stocks of small-cap companies have less liquidity, resulting in larger spreads and possibly higher trading costs.
• Risk tolerance and investment style: The market cap of companies helps traders pick stocks that align with their level of risk tolerance. Those with a higher level of risk tolerance may choose smaller-cap stocks, while those that have lower risk tolerance go for larger-cap stocks.
• Investment style: Market cap plays a crucial in determining the investment style of an investor. Value investors pursue opportunities among large-cap stocks which they believe to be undervalued. Growth-oriented traders concentrate on smaller-cap stocks that have significant potential for growth.

Summing up

The market cap is among other factors to take into consideration when making decisions about investments. Even though the information is vital, thorough research with regard to other financial metrics is always needed to assess companies' financial health and to evaluate their competitive position. After considering their own financial goals and risk tolerance, market cap can help to make better investment decisions in the short run, as well as the long run.