When you're new to the investment world, listening to seasoned investors or reading financial magazines can leave you feeling overwhelmed. There's a whole specialized vocabulary to learn, along with fancy-sounding concepts like market capitalization. Market capitalization is just a convenient way of dividing companies into small, medium and large sizes for comparison purposes, which is why you'll often hear mutual funds described as "small-cap" or "large-cap." Companies in any size category have both strengths and weaknesses you'll learn to recognize.
Understanding Market Capitalization
Market capitalization is a simple calculation. Multiply the number of a company's shares by its current stock price, and that's the market cap. For example, a company with 20 million shares trading at $10 would have a market capitalization of $200 million. As of 2012 the term large-cap usually refers to companies with a market capitalization of $10 billion or more. Mid-cap companies have a market cap between $2 billion and $10 billion, and small-cap companies are between $300 million and $2 billion. Some firms place the dividing lines higher or lower, depending on their investment objectives. These definitions change over time to reflect increases in stock market values.
Large-cap companies with market capitalizations of $10 billion or more are mature companies with a long track record. They're generally companies you grew up with, and own or control brands you know. To use another common investing term, they're reliable "blue chip" companies. In general, they're safe and stable investments. They're well established and seldom have drastic demands on their capital, so they often pay dividends that can be useful in a growth or income portfolio. Some investment firms now define a class of extra-large "mega cap" companies with market caps of over $200 billion.
Small-cap companies occupy the other end of the spectrum. Many of them are relatively new, or are in emerging industries, and haven't yet reached a serious level of expansion. Others are more established, but are size-limited by market factors. Small-cap companies are more difficult to research, since they're often overlooked by market analysts, magazines and commercial research firms. However, they're sometimes undervalued for the same reasons. That treasure hunter attitude makes small-caps appealing to investors who are willing to do the necessary research. Market giants such as Wal-Mart and Microsoft were once small-caps, and made a lot of early investors look very, very smart.
Large-Cap vs. Small-Cap
Both large-cap and small-cap companies have their strengths and weaknesses. Small-cap firms are more volatile and might not have the financial reserves to survive several years in a bad economy. On the upside, they can hold the potential for better returns. Large-cap companies are more robust and less likely to fail in bad times, though the 2008 to 2009 economic downturn showed that they're not invulnerable. "Blue chip" companies can be left behind by changing technology, or adapt to newer markets as IBM has over the decades. Intelligent investors usually hold portfolios with small, medium and large companies in varying ratios, depending on their investment goals.
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