Building a profitable stock portfolio is, of course, the main goal of any investor. If you’re a beginner trader, a big part of your path to success is knowledge. Today we’ll cover two key indicators to consider when choosing the right stocks; the difference between market capitalization and market value, and how it influences your investment choices.
Two types of commonly used analysis:
- Technical analysis focuses on market price variations and the search for patterns of these movements.
- Fundamental analysis focuses on the company’s fundamentals, which is financial and marketing indicators.
Both are complementary and could help at the time of allocation of resources and generate returns.
This is a recurring theme when analyzing companies to invest in. Simply put, market cap is the amount of money it would take to buy every stock of a company for the current market value.
For example, if a company has $2 million stocks on the market and each one is worth $50, then it would cost $100 million to buy them all. This number is considered the company’s market cap.
This is an important concept because it allows investors to understand a company’s value when compared to others.
The most important factor investors should consider about market cap:
It’s evolution! This indicator/index reveals if the company is growing or shrinking over time. Good companies tend to grow their market cap over the years and decades, while others tend to decrease it in the long run.
So, following up on the market cap of a company may give investors a good indication if a company is adding value for shareholders or not.
On the other hand, market value takes numerous factors into account to create a broader picture of a company’s financial standing. It measures the company’s monetary value based on a number of valuations and ratios, such as price to earnings, return on equity, long-term growth potential and the company’s assets and liabilities.
Market value gives a clearer perspective of the company, compared to the market cap that shows some inadequacies when it comes to evaluating the size of a company. The most important one is that the market cap doesn’t take the company’s debts into consideration. For example, a company could be worth $100 million, but can have $20 million in debts, so its real worth would be $80 million.
How to use the market cap to build a healthy portfolio
Many professional investors allocate their assets based on a companies’ market cap. They believe the approach allows them to take advantage of the fact that small companies have historically grown faster, while the big ones pay more dividends.
Market cap categories to watch:
- Micro-cap: companies with a market cap below $300 million.
- Small-cap: companies with a market cap between $300 million and $2 billion.
- Mid-cap: companies with a market cap between $2 billion and $10 billion.
- Big-cap: companies with a market cap between $10 billion and $50 billion.
- Mega-cap: companies with a market cap over $ 50 billion.
Of course, this is not the only classification, and the range of values is not standardized. But, how should it inform your asset allocation strategy?
Market capitalization and its importance to investment strategy
Generally, market capitalization corresponds to a company’s stage in its business development. Typically, investments in large-cap companies are considered more conservative than investments in small-cap or midcap stocks.
Mid-cap companies may be in the process of increasing market share and improving overall competitiveness. This stage of growth is likely to determine if a company will live up to its full potential. So, mid-caps offer more growth potential than large caps.
Small-caps, on the other hand, are more susceptible to a business or economic downturn and could also be vulnerable to competition and untried markets. However, they may offer significant growth potential to long-term investors, who can tolerate some more risk.
Selecting the right combination
Although diversification doesn’t eliminate risk or the risk of potential loss, a diversified portfolio that contains a variety of market caps can help reduce investment risk in any area and support the pursuit of your long-term financial goals.
Analyze your financial goals, risk tolerance and time horizon to build a portfolio with the proper mix of small-cap, mid-cap and large-cap stocks.