Equity Market Value, commonly referred to as “market cap,” is calculated by multiplying number of shares outstanding by the current market price per share. The investment community uses this figure to determine a company’s size, as opposed to using sales or profitability or cash flows or total asset figures. Stock price per share does not give an idea of how big or small is a company. See table below.
Market cap is a comparable measurement for companies competing each other — peer valuation. People often associate market cap with known and unknown companies, but classification is done as per SEBI’s guidelines.
Classification of companies by market cap as per SEBI’s guidelines
So, is market cap an important investment criterion?
The answer may be ‘yes’ if you are a Mutual Fund, AIF or a PMS as quantum of each purchase and liquidity available in the stock become important factors. These are closely linked to free float market cap or non-promoter holding.
However, for an individual investor market cap may not be the most important investment criterion. Currently, the belief is that Large caps are safe and Mid and Small caps are risky. The question is how does one perceive risk for a short-term trader, Price, Volatility Risk or Sigma may be more important. But for a long-term investor Business Risks in a company that can impact the growth trajectory of its earnings are greater risks. Take a look at the table below:
So, Large caps are safe and Mid and Small are risky, correct?
Not really. We have seen big businesses collapse on account of (i) poor management; (ii) inability to respond to changes in macro factors; (iii) competition; and (iv) over-leveraged balance sheets, to name a few factors. The table below indicates level of Price Volatility Risk and Business Risk by market cap:
Conclusion
A Particular market cap alone may not provide the deciding investment hypothesis. This also means a long-term investor diversifying (within equities) using ‘market-cap’ — may consider diversifying keeping ‘business risk’ in mind.
A long-term investor should invest in good businesses. The right investment criteria may be a combination of the following: (i) experienced management, (ii) sound financials, (iii) growth potential; and (iv) compelling valuation. These coupled with zero tolerance corporate governance would be right criteria for investment.
This article was published on FPPulse special edition 2019 which was launched during CoFP India Retreat 2019
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