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What Is Market Capitalization And Why Does It Matter?

Published : June 14, 2019

What Is Market Capitalization And Why Does It Matter To A Retail Investor

As an investor in the stock market, you need to know about various characteristics of a company that is part of them. This is important as it will assist you in understanding the very nature of the company whose share might interest you. One of such basic determinants of the company’s essential characteristics is the size of the company. And you know, there is a concept that helps in understanding such size aspect. It is market capitalization.

Yes, market capitalization helps understand the size of a company. Market capitalization is nothing but is the market value of the shares of that company. It is crucial in determining the size of the company. Before we move further in understanding the very concept of market capitalization let us understand that as a retail investor why the size of any company is significant.

Does the size of the company matters to a retail investor?

The size of the company may do not have any direct effect on a retail investor. However, it is always good to be aware of the size of the company before investing. For instance, consider this example. Let us assume the stock prices of two big Indian companies as –

MRF – INR 56700

HDFC Bank – INR 2440

Presently, based on the above share price on some date, what do you think, which company is bigger? As a layman, you might think MRF with huge share price will be a bigger company than the HDFC Bank with a lower share price. But this is not true. Consider the market cap of both the companies on that same day –

The market capitalization of MRF – INR 24400 crore

The market cap of HDFC Bank – INR 668720 crore

Do you see? The market cap clearly suggests that HDFC bank is bigger than MRF.

Now back to our original question. Does size matter? So, to fulfill the financial goals, it is crucial for investors to know the relationship between the size of the company, its return potential and the risk involved in investing in it. It is also a fact that the market capitalization has a role in valuing a company’s stock. It does help in comparing companies with their peers. Moreover, it suggests about the future prospects of the company as well.

You can arrive at the value of market capitalization simply by multiplying the total shares out in the market of the company by its market price. For example, a company “X” with 15 crore shares out in the market and a market price of INR 25 per share will result in the market capitalization of INR 375 crore.

Before proceeding further on the concept of market capitalization, let us look into the types of market capitalization briefly.

Types of market capitalization

Generally, the following are the four types of market capitalization –

  • Large-cap shares
  • Mid-cap shares
  • Small-cap shares
  • Micro and nano cap shares

1. Large-cap shares – Large capitalization stocks have a market capitalization of more than 10 billion dollars. However, if the market capitalization crosses over 200 billion dollar mark, they come under mega-cap shares.

Characteristics of large-cap shares –

Most of the large-capitalization companies are highly stable.

They usually dominate their industry.

Such companies tend to be less volatile even in the rough market conditions.

2. Mid-cap shares – Companies with 2 billion to 10 billion dollar range of market capitalization comes under mid-cap shares. In general, such mid-cap stocks attract retail investors most. This is so because they tend to offer more growth potential. But, they are risky than large-cap stocks.

3. Small-cap shares – The companies with their market capitalization of less than 2 billion dollar falls under this category. The important characteristics of small-cap companies are that they are relatively young companies. They also offer huge growth potential. But at the same time, the risk of failure of their business is also huge. Thus, they are the most volatile.

4. Micro and nano-cap shares – Companies with their market capitalization ranging between 50 million to 2 billion dollars comes under micro-cap shares. Furthermore, companies with a market capitalization of fewer than 50 million dollars are nano-cap shares. As most of these companies are new entrants in the market they offer opportunities to extreme growth with a huge risk to lose as well.

There is one another way of classification of stocks in the Indian market. It is mainly on the volume of trade in a particular stock in any trading day. Here again, it is not necessary that the stocks will remain in one category forever. As the volume of trade increases or decreases, the category changes. The NSE classification of stocks is three is number and is for the margin calculation. On the other hand, BSE India classification of stocks is more detailed. It has more than five sub-categories of stocks.

Classification of stocks in India on a market capitalization basis

Though the basic idea of the classification of stocks remains the same in India, it is done a little differently. In India, the SEBI assigned AMFI to categorize all listed stocks based on market capitalization. On a market capitalization basis, AMFI came out with the list of stocks and has put them into the following three categories

Market capitalization

Classification

The company has a market capitalization of more than INR 28000 cr Large-cap
A company having a market capitalization in the range of INR 8500 cr to INR 28000 cr Mid-cap
The company has a market capitalization of less than INR 8500 cr Small-cap

In the Indian stock market, large-cap companies cover 80% of the total market capitalization. Next to it comes the mid-cap companies and covers the next 15% slot of the total market capitalization. Similarly, the remaining 5% of the total market capitalization is the small capitalization companies. Let me make it more clear with the help of the following table:

Percentage of total market capitalization

Classification

80% Large-cap stocks
15% Mid-cap stock
5% Small-cap stocks

You must remember that the market capitalization and the share prices are two very dynamic in nature. Therefore, there is no fixed classification for any company to be under any of the above class. A company can fall under any of the classifications anytime. A company that was large-cap five years ago might not be in that list now.

What makes the market capitalization important to the retail investor?

We now understand that market capitalization helps determine the size of the company. The importance of the market capitalization for a retail investor is as follows:

  • Market capitalization determines the size of the company which is the important determinant to know for the investors.
  • It facilitates in the comparison of various companies and thereby helps investors to select the company based on their risk and return criteria.
  • The other important determinants in which investors are usually interested such as risk and return depends on the size of the company.
  • The size of the company often tells the investors the phase in which the company is operating.
  • It helps the investors to choose their preferred investment avenue on the basis of their risk-return appetite.

How to calculate market capitalization?

The process of calculating market capitalization is fairly simple. You can calculate it as the value of the total outstanding shares of the company at their current market price.

The formula for its calculation is:

Market Capitalization = Number of total outstanding shares* Market price per share

However, there is another method to calculate the market capitalization as well. It is more precise and is more accurate. We call it the “Free Float Method of market capitalization”.

In every company, promoter holds a certain number of shares. These shares are excluded from the calculation of market capitalization under the free float method. Apart from the promoter’s holding, Free float method of calculating market capitalization also excludes:

  • Shares that are locked in
  • The shares that are acquired by direct foreign investment
  • Shares that are with a government

In other words, the free float method of market capitalization excludes the shares from the calculation of the market capitalization that is not available for trading. This method of calculating market capitalization is more widely in practice.

The formula of calculating market capitalization under free float method is:

Market capitalization= (Number of outstanding shares – locked in shares)* Current market price of the share.

Let us now move to the large-cap stocks.

Large-cap stocks in the Indian market

Large-cap companies are mostly blue chip companies in India. These companies are into the business for a longer period of time and have gained investor’s trust. Their size suggests that they can withstand turmoil in the market better than the mid-cap or small-cap companies.

Mostly, the dominating companies fall under this category. Most of the large-cap companies also have diversified business i.e. they have a business in more than one sector.

Some of the examples of large-cap companies in India are Reliance Industries (RIL), Hindustan Unilever (HUL), Tata Consultancy Services, etc. As already suggested the market cap does not remain constant owing to the changes in the share price.

Here is the list of top 10 large cap companies in India – SEBI list of market-capitalization

Characteristics of large-cap stocks

Let us have a look at some common characteristics of the large-cap stocks

1. Market-dominating: One of the most common characteristics of the large stock companies is that they are the market leader in their segment.

2. Diversification: The large-cap companies most often diversify their businesses. They have their business in different segments and sectors. It gives them more opportunities to grow their earnings and strengthen their future too.

3. Dividend: Mostly, the large-cap companies have a steady income and they pay regular dividends to their stockholders.

4. Stable: Most of the large-cap companies are stable and are in the mature phase of growth.

5. Safer: Large-cap companies offer a safer avenue for investment. They are stable and mature and hence there is no risk of them going out of business. Thus, they are preferred by risk-averse investors.

Now, the advantages and disadvantages of investing in large-cap companies can be summed up as follows:

Advantages of investing in large-cap stocks

The following are the advantages to a retail investor for investing in large-cap stocks –

1. Transparent: Large-cap companies are stable and are more transparent. Transparency is a great advantage for investors. They know where they are investing and are certain of not losing their money.

2. Liquidity: liquidity is another advantage for investors. The investment in large-cap companies is more liquid. The investors can withdraw the amount invested anytime by selling the shares.

3. Lower risk: Blue-chip companies have better management, proven track record, and steady earnings. Therefore, these companies are considered as safe for investment.

Disadvantages of holding large-cap stocks in your portfolio

Large-cap stocks are not free from shortcomings. Their disadvantages can be summarized as follows:

1. Less growth: As most of the times the large-cap companies are already in the mature phase of growth there is very little chance of growth. Thus investing in large-cap companies often results in no or little wealth creation.

2. Lower Returns: As these companies have lower or no possibilities of growth the return on investment is less. The share price is already high and therefore the sum invested in these companies is high. Low returns on huge investment often hurt the investors.

Despite these disadvantages, there are certain reasons that allure investors to invest in large-cap companies. During the downturn in the business cycle, large-cap companies are able to handle adversity in a better way. The other reason is that as the earnings are stable and regular they reward their investors by paying regular dividends. Risk-averse investors feel safe to invest their funds in the large-cap companies without hesitation.

Benefits of holding large-cap stocks in your long term portfolio

It is always advisable to hold a diversified portfolio to fulfill one’s financial goals in a stipulated time. A well-diversified portfolio has a right mix of small, mid and large cap stocks. A well-diversified portfolio offers great growth opportunities and at the same time provides stability of returns to the investors.

Investors should allocate funds to the diversified portfolio as per their risk appetite and also keeping their financial goals in consideration. Often Investors who are middle-aged or older have a moderate risk appetite. Also, their investment horizon is not long. On the other hand, young people may have a higher risk appetite and a longer investment horizon.

Even if the investors have good risk tolerance capacity, it is advisable to have large-cap stocks in the portfolio. Large-cap stocks might not help in wealth creation but they help in adding the element of stability to the portfolio. The exposure to the large-cap funds reduces the volatility of the portfolio and thereby generates stable returns.


“If you are looking to invest in large-cap stocks, you must not wait. Register yourself with RMoney India and one of our representatives will contact you with every detail on it. “


 

About Author

Naresh Kumar Sharma
Naresh Kumar Sharma

Naresh is the head of Research at Raghunandan Money. When it comes to studying the markets, Naresh is someone loves decoding prices, data, trends & charts. Naresh carries an equal flair for both technical and fundamental analysis and that makes him truly one of the reliable experts in the market. Naresh writes informative articles & blogs for equity, commodity, traders and investors.

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