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Understanding market capitalisation is key if you want to make smarter investment decisions when trading stocks, as it will help you fine-tune your investment choices by selecting the right company size based on your profile, the associated growth potential and risk. So, keep reading this beginner's guide to find out what market capitalisation is and how it can help you choose how to invest in the stock market.
Market capitalisation, or simply market cap, serves as an indicator of a company's size in the stock market. Calculating it is straightforward – simply multiply the number of outstanding shares of a company by the current market price of its shares.
Let's use the Australian telecommunication company Telstra (TLS) as an example:
While the specific market capitalisation categories may sometimes vary from one country to another, the common classification often includes the following breakdown:
Today's large-cap stocks, such as Apple (AAPL) or Microsoft (MSFT), had initially humble beginnings, with small market capitalisations when they first went public.
So classifying a company's shares based on market capitalisation should not be considered a static measure, as share prices fluctuate daily and the number of shares can also change over a company's history. Additionally, mergers and acquisitions can lead to a company disappearing or transitioning from one category to another.
As it classifies stocks based on company size and enterprise value on the stock market, grasping the concept of market cap is crucial for getting a better idea of the value of a company, as well as its growth prospects and associated risks. This understanding is key to making well-informed stock market decisions that will fit with your investment strategy.
Market capitalisation also holds significant importance in the world of business deals, such as mergers and acquisitions (M&A), asset purchases or partnerships, which can also have an impact on your portfolio. It is, for instance, used by acquirers to assess the financial worth and strategic fit of potential targets before any business and financial transaction.
Additionally, fluctuations in market cap play a crucial role in determining which companies enter or exit the composition of indices, which are baskets of stocks generally representing an economy or a sector. For instance, the S&P/ASX 200 includes the largest companies with float-adjusted market capitalisation listed on the ASX stock exchange.
Every trader and investor is unique, with distinct personality traits, preferences, financial education, trading experience, risk tolerance levels, and financial objectives. Additionally, different market capitalisation categories have their own characteristics, advantages, and risks. Therefore, you should always assess your trader profile before deciding whether to focus on trading smaller or larger companies.
Now, let's explore the pros and cons of trading each type of market valuation.
Small-cap stocks typically represent relatively new and innovative companies, though they aren't always startups. These companies often have the potential for rapid growth, thanks to their reactivity and agility in capitalising on emerging or niche trends and markets.
An additional advantage of companies with lower market capitalisation is that they receive less market coverage from market participants and analysts compared to larger companies. This can create opportunities for you to identify unrecognised potential in the market.
However, this reduced attention also means that it can be more challenging to find reliable information about these companies and evaluate their competitive advantages, fundamentals, and intrinsic value, leading to potentially higher risk for your investments.
Smaller companies usually possess fewer financial resources and less experience in navigating economic downturns and sustaining growth compared to larger companies. Also, not all brokers offer small-cap trading options, which can limit your ability to invest in this market. Additionally, small-cap stocks are often characterised by higher volatility and lower liquidity.
Mid-cap stocks typically represent companies that have moved beyond their initial growth phases and are moderately established in their market, offering a sense of security akin to large caps, while also presenting greater growth potential similar to small caps. They are less volatile and more liquid than small caps, but they are generally riskier than large caps.
Large-cap stocks are the most popular kind of stocks among beginner traders and investors, as they typically represent well-known and popular brands with strong track records. These companies display robust and steadily growing finances, bolstered by loyal customer bases and popular products, which allow them to distribute rising dividends to their shareholders.
Large-cap stocks are also known for being the least risky and most cost-effective stocks to trade, as they exhibit lower volatility and high liquidity. Moreover, you can find a lot of information available to conduct your analysis.
Even though they are considered less volatile than other companies, even large-caps can experience downturns or financial difficulties leading to bankruptcy. They also face shareholder pressures for consistent results and dividend distribution, potentially limiting their innovation capabilities and growing prospects.
With FP Markets, you can access over 10,000 Australian and international share CFDs to kickstart your investment journey in the stock market. Read our complete guide to discover how to buy and trade shares through CFDs today!
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