Beginner investors will quickly find themselves with questions about market capitalization. What’s small cap vs. large cap? Why does market cap matter? Is one better than the other? There are a multitude of questions worth asking and answering about market cap. The first and most important is what the distinction between small and large caps is.
Understanding the difference between small and large cap companies plays a big role in shaping many investors’ strategies. It can determine risk tolerance and time horizon. It can also determine what kinds of companies a person invests in or what sector they gravitate toward. Most importantly, understanding market capitalization helps inform better investment decisions. Here’s what you need to know.
The Definition of Small Cap
Small cap companies are worth $300 million to $2 billion. For example, a company with 200 million shares at a price of $8 per share would have a market cap of $1.6 billion—well inside small cap range. Small caps rank above micro caps and below mid caps, but can trend into either of these territories depending on how they perform.
These companies represent the most prolific group of publicly traded companies, and tend to have a long runway for momentum. With the right leadership, small caps offer the potential for great growth.
Advantages And Disadvantages of Small Caps
The primary advantage of small caps is their friendliness for retail investors. Institutional investors steer clear of most small caps because they can’t purchase shares in bulk. SEC regulations prevent mutual funds from owning more than 10% of the voting shares of a company. This leaves retail investors in control of small caps and their behavior in the market.
Lack of institutional investor intervention makes small cap stock prices more volatile. While this is a good thing in terms of profitability, it can be inversely detrimental. Many small cap companies struggle to overcome financing issues, bad PR, leadership changes and more. Share price can languish during a downturn, souring investors. Moreover, it can be difficult to unload shares due to low liquidity—again due to lack of institutional investors.
The good news is that retail investors have the opportunity to get in on companies with a long runway for growth. Well-run small caps can quickly become mid and large cap companies under the right leadership and with the right trajectory. Innovative positioning and a good moat can take a company to new heights and generate huge returns for patient investors.
The bottom line is that small cap stocks carry a lot of risk and a lot of potential reward. It can take time to see a payoff, but early entry into a promising small cap stock can result in highly profitable returns—if the stars align.
The Definition of Large Cap
Large cap companies tip the scales at valuations of $10 billion to $200 billion. They fall short of mega cap companies that can reach valuations into the trillions. For example, a company with 2.8 billion shares outstanding at a price of $50 per share would have a market cap of $140 billion—a large cap valuation. It’s rare to see large caps trend up or down into a different level of capitalization, but it does happen occasionally.
Large cap companies tend to be ubiquitous brands. They’re multinational enterprises or highly profitable conglomerates that can grow to a large market cap and sustain that production. Many of these companies even choose to pay a dividend. For the most part, they represent stability.
Advantages And Disadvantages of Large Caps
Large caps are bellwethers. These are companies that have proven themselves capable of growth and sustained success. They have access to capital and established revenue streams that allow them to support new growth—and weather economic hardship. Investors tend to have favorable outlooks and more trust in large cap companies.
The drawback—at least for retail investors—is the tremendous volume associated with these companies. Billions of shares can change hands daily, and institutional investors can move the needle on any given day. There’s less opportunity for small investors to capitalize. Or, in market terms, the success of large cap companies is “priced in.” This isn’t to say that they can’t get bigger—it just takes more to move the needle.
Large caps also have the benefit of broad coverage. There’s always investing news about Netflix (Nasdaq: NFLX), McDonalds (NYSE: MCD), Amazon (Nasdaq: AZMN) and others, making it easier for investors to access information without necessarily understanding fundamentals. Investor sentiment is easier to come by.
The bottom line on large cap stocks is stability. Lower risk doesn’t necessarily mean lower reward, either. Long-term investors in a bull market can see great returns from established companies.
Small Cap vs. Large Cap Changes
It’s important to realize that there’s a whole range of companies between small and large caps. Mid cap companies represent capitalization of $2 billion and $10 billion. It’s exceedingly rare for a company to go from small to large or large to small overnight. More often, they flirt with mid cap classification. It’s a good intermediary between the two chief market segments.
And this is why it’s important to gain a better understanding of the stock market. For expert stock analysis and investment education, sign up for the DailyBusiness e-letter below.
It’s important for investors to watch their investments. If a small cap is picking up steam fast, it could be a large cap in just a few years. And while it’s unlikely that a large cap stock will lose enough value to become a small cap once again, it can happen. Use the mid cap range as a barometer for your investment, no matter if you prefer a small cap vs. large cap or vice-versa.