Why Market Caps Matter When Buying Stocks

One of the first things that investors should look at when buying a stock is the market capitalization, which is the total dollar value of all of the company's shares. You can calculate it by multiplying the price of a stock times the total number of shares outstanding. Since market caps change on a daily basis as a stock's price goes up or down, the valuation of a company can change significantly, and tracking it can help you determine what your expectations for an investment should be. The market cap of a stock can also be used to determine the underlying value of an enterprise. Think of it as a stock's net worth. And because the size of a company relates directly to the investment risk involved, there are three common types of market caps you should be familiar with: 1. Large Cap Stocks Large cap stocks are companies that are valued over $10 billion dollars, like Microsoft MSFT, Walmart WMT, and Exxon XOM. All three of these companies have market caps of more than $200 billion dollars. Large cap stocks are viewed as much less risky because their sheer size makes them less subject to drastic price swings than stocks with smaller market caps. Large cap stocks typically have more assets on their balance sheet, providing some level of security for investors. They also can be quantified by higher sales revenues and cash flows than smaller companies. Large cap stocks are attractive to many mutual fund companies, pension plans, and institutions. The bottom line is that large cap stocks provide much-needed stability and liquidity, but they do not have great growth potential. 2. Mid Cap Stocks Mid cap stocks are companies that fall right in the sweet spot between small and large cap stocks. They have market valuations that range from just over $1 billion dollars to slightly under $10 billion dollars. They have a reasonable dollar amount of assets and are often on their way to large cap status. Investors are often attracted to mid cap stocks because they get the best of both worlds: more safety than small caps can offer and more opportunity for growth than large cap stocks offer. 3. Small Cap Stocks Small cap stocks are companies that are valued at $1 billion dollars or below. These are companies that range from startups to companies rapidly increasing in sales. Small cap stocks are more risky, but they are a favorite of growth investors because they have the potential to generate tremendously high returns since they are commonly overlooked and undervalued. Every investor hopes to uncover a small cap stock that turns into the next Microsoft. Small cap stocks have much lower cash flows, revenue totals, and assets, and they also are much more illiquid than their large cap counterparts. Many of these companies never make it into the phase of becoming a much larger company. Final Thoughts Market capitalization is one of the first things you should consider when it comes to investing. Your expectations for return on investment and the amount of risk involved relate directly to the size of the company that you are seeking to buy. For less risk, but low growth potential, seek out large cap stocks. For high-risk, but great growth potential, seek out small cap stocks. Mark Riddix is an investment management professional for his company, New Horizons Financial Management. Mark also contributes his investing expertise to MoneyCrashers.com, a resource site and blog about personal finance topics. He writes a weekly column for Benzinga every week.