Investors often struggle to understand the complex dynamics that drive stock prices higher or lower from day to day. Learning how these factors shape certain market trends underpins the very foundation of asset allocation and portfolio management. By and large, this means balancing risk against performance through a diverse selection of stocks and bonds across a wide range of market capitalizations.
Market Capitalization—or market cap, for short—is still considered the standard measure of a company’s size and financial performance. It is determined by multiplying the current price per share by the total number of outstanding shares. Apple (AAPL), for example, has 5.2 billion shares outstanding and trades a smidge over $155—putting its valuation just north of $800 billion.
If the stock appreciated by 25% it would lift the tech giant’s market capitalization by the same amount and make it the first trillion-dollar company; however, a dip in price would have the opposite effect. In most cases the total value of a company rises and falls with changes in share price.
Deviations in the number of outstanding shares also have a hand in determining a company’s valuation. When management decides to issue new shares or exercise a warrant, it tends to have a dilutive effect on existing value as the offer is made at a discount from the current list price.
Corporate events such as stock splits and dividends, on the other hand, have an inverse impact on market price and outstanding shares, resulting in an unchanged market cap. In other words, a corporate action that increases the number of outstanding shares will also elicit a decline in price by the same amount as the dividend payment or split.
Moreover, market cap is a powerful tool to manage expectations and set investment goals; large cap stocks exhibit more stable returns with a history of dividend payments whereas small companies boast significant growth potential and volatility. A standard mix of small, mid, and large cap stocks help reduce investment risk while maximizing long-term returns.
In the past, this meant selecting small stocks valued between $300 million and $2 billion, medium sized ones in the range of $2 and $10 billion, and large cap companies valued over $10 billion. But as the market storms to new all-time highs, traditional benchmarks have also changed.
What was once considered a large cap stock 30 years ago is now considered small. Take JC Penney (JCP) for example. The beaten-down department store is down to a mere $1.1 billion; a small cap by standard classifications, but a micro-cap based on today’s market conditions.
It is true that cap size tends to correlate with risk and return, but as demonstrated by Amazon’s (AMZN) recent run, this assumption does not always hold. Shares of the retail giant increased by 27 percent year to date and nearly 300% in the past 5 years, compared to an 83% jump by the Russell 2000—the de facto index for tracking small, growth companies.
In spite of the aggressive movement, investors can still look at large stocks as a safe bet when volatility emerges. Large companies are better equipped to weather market turbulence or an economic downturn that slows down fundamental performance. They often generate revenue from multiple different sources, whereas smaller companies rely on a single product.
Although market cap is a well-known investment tool, there are several popular economic indicators grounded in the value of equities. The Buffet Indicator, for instance, gauges the health of the economy by taking the percent of total market capitalization relative to gross domestic product (GDP). If the metric rises above 100 percent, as it has today, conventional wisdom suggests stocks are expensive, whereas a reading between 75 to 90 percent represents fair value. Other variations of the Buffet Indicator substitute GDP with revenue or sales as a way to compare stock valuations.
And yet, there is a common misconception that price per share offers more valuable information than market capitalization. Many investors mistakenly view price as a window into sales and profitability, but the actual price tag means very little without considering other factors.
This misguided approach feeds into the incorrect perception that inexpensive stocks signify potential value when the truth is stocks can trade at a bargain due to fundamental problems.
Looking at share prices alone can lead investors down a dangerous path wrapped up in risky and ill-advised decisions. Instead, focus on market capitalization and other underlying fundamentals for an honest depiction of a company or stock’s value.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.