Market cap is a trading term that every investor needs to understand as it is fundamental to determining whether or not a company is over- or under-valued. As well as defining the term and showing how it is calculated, this article discusses how it can be used to build a well-balanced portfolio.
What is market capitalisation?
The most common method for calculating the value of a company is to look at its market capitalisation – often referred to as the market cap. This is the value of a company based on the perception of how much investors are willing to pay for its shares.
The word perception is important here, as the market cap does not determine the amount the company would cost to acquire. Rather, the market cap would help determine whether or not the shares of a company were over- or under-valued at that precise point in time.
How is market capitalisation calculated?
Market cap is equal to the share price multiplied by the number of shares outstanding:
Market Cap = Share Price x Shares Outstanding
Accordingly, a company with a lower share price can often have a higher market value, providing it has more shares outstanding. The share price simply tells us the price it costs to buy a piece of that company, and not the overall value.
How are companies ranked by their market cap?
Companies are often classified by their market cap into large-cap, mid-cap and small-cap. The barriers between these different classifications vary, but can be thought to be around about the following:
- Large-cap: Over £10 billion
- Mid-cap: Between £1 billion and £10 billion
- Small-cap: Between £200 million and £1 billion
The term micro-cap is used to refer to any company with a market cap below that of a small-cap company. Such companies constitute the popular term, penny stocks.
Interestingly, based on the above classification, the FTSE AIM Market would currently have the following spread of companies:
- Large-cap: 0 companies (0%)
- Mid-cap: 13 companies (1.5%)
- Small-cap: 97 companies (10.9%)
- Micro-cap: 783 companies (87.7%)
This article is regularly updated with the largest and smallest market cap companies on AIM.
Why is market capitalisation an important metric for investors?
As already mentioned, the market cap can be used to determine whether or not a company is over- or under-valued when compared to others in their particular industry or sector – rather than looking at the current share price, which isn’t the correct indicator for its market value.
Not only this, the market cap is also used to help investors diversify their portfolio. This is due to the different levels of risk and reward associated with larger- versus smaller-cap companies. For instance, having a much higher percentage of larger-cap companies could limit your potential for growth, whilst a higher percentage of smaller-cap companies could be deemed to be too risky.
Considering the variety in market cap size on AIM, one could develop quite a well-balanced portfolio simply off of its constituents without ever having to look to the Main Market. Reflecting this, there are already a large number of organisations that run AIM Portfolio services – most often related to Inheritance Tax – as discussed in this article on AIM tax advantages.