How does market capitalization influence investor decisions?

There are fewer than a dozen companies with a market capitalization of over $1 trillion. Apple, Microsoft, NVIDIA, Alibaba, Amazon, Google, and Citigroup- we associate such companies with stability, market leadership, and proven track records.

Then, what about companies with low market capitalizations? Do we place the same amount of trust in a $1 billion company as we do in a $1 trillion company? Most of us would not. At the same time, how many of us would be willing to bet that a $1 trillion company would double in size? A much larger number of investors would be willing to take that bet if we were talking about a $1 billion company.

A company’s market capitalization has a huge impact on how investors perceive it. In this article, we will explore how this financial metric influences investor decisions by influencing the perceived risks and growth potentials.

What is market cap?

Market capitalization or market cap is a measure of a company’s value. We calculate it by multiplying a company’s share price by its total outstanding shares, which includes stocks held by all shareholders, including retail investors, promoters, and institutional investors.

The concept of market cap applies only to publicly traded companies. This is because there is no active ‘market’ for private companies whose shares do not trade on stock exchanges.

Market capitalization formula

Market cap = Share price × Total outstanding shares

US market cap categories

Earlier, companies used to be categorized into large, small, and medium-cap categories. However, as the US equity markets grew in size, investors found the following classification more practical.

Market cap category	Market cap
Mega cap	More than $200 billion
Large cap	$10 billion to $200 billion
Medium cap	$2 billion to $10 billion
Small cap	$300 million to $2 billion
Micro cap	$50 million to $300 million
Nano cap	Up to $50 million

How does market capitalization influence risk perception?

Investors perceive market cap as an indicator of a company’s risk profile. Basically, larger companies with higher market caps are considered less risky than smaller companies with smaller market caps. The rationale is that a larger company has better chances of surviving a crisis. After all, it must have better cash reserves, better reputation, more stable operations, more secure supply chains, and better access to talent.

In the worst-case scenario, the large company will have more room to downsize before it must shut shop as compared to a smaller company.

Take Walmart and Ollie’s Bargain Outlet Holdings, for instance. They are both discount stores. Walmart is a $600 billion company that operates over 10,000 stores and has more than 2 million employees. In contrast, Ollie’s Bargain Outlet Holdings has a market capitalization of about $6 billion, has less than 600 open stores, and about 11,000 employees. While Walmart is a global brand, Ollie’s has stores only in the US.

If this were the only information available to you, you would assume Walmart has a better chance of surviving any kind of crisis that affects both companies. In fact, you are likely to simply assume that Walmart has a better chance of survival, even before you learned about how geographically diverse Walmart is in comparison to Ollie’s or how many more stores and employees it has than Ollie’s.

Thus, a company’s market cap influences an investor’s risk perception.

How does market capitalization influence growth potential perception?

A company’s market cap is often seen as an indication of its growth potential. The rationale is that a large company has less room to grow than a smaller company. A small company can grow by simply capturing more of the market share. However, for a large company to grow, the size of the market itself may need to grow. Hence, investors may believe that a small company is more likely to exhibit a high CAGR than a large company.

This rationale also fits nicely with the need for high risk to be rewarded with higher growth potential.

To understand how market capitalization influences growth potential perception, let us consider the telecommunication services industry.

Name	Market Cap (in billions)
China Tower Corporation Limited	$355.12
T-Mobile US, Inc.	$286.64
AT&T Inc.	$198.33
Verizon Communications Inc.	$182.28
Deutsche Telekom AG	$178.33
Deutsche Telekom AG	$170.82
Comcast Corporation	$129.41
Nippon Telegraph and Telephone Corporation	$86.21
Nippon Telegraph and Telephone Corporation	$86.04
SoftBank Group Corp.	$73.92
SoftBank Group Corp.	$73.21
SoftBank Corp.	$71.06
SoftBank Corp.	$70.54
KDDI Corporation	$70.04
América Móvil, S.A.B. de C.V.	$59.29
Charter Communications, Inc.	$54.46
América Móvil, S.A.B. de C.V.	$52.52
Singapore Telecommunications Limited	$49.86
Singapore Telecommunications Limited	$48.19
True Corporation Public Company Limited	$43.91
BCE Inc.	$41.79
Orange S.A.	$39.55
Orange S.A.	$38.52
Globalstar, Inc. Common Stock	$37.24
Telstra Group Limited	$34.47

Source: Yahoo Finance

The growth rate of the telecommunication services industry depends mainly on population growth and economy-wide income trends. As many users moved to online messaging, calling, and video calling, only a limited amount of money is spent by each user on mobile and telephone plans.

Hence, the growth rate of large companies such as T-Mobile, AT&T, and Verizon Communications will be quite low. In contrast, smaller companies could grow much faster by simply capturing the market shares of competitors with similar market capitalizations.

Market cap and stock indices

Various stock market indices are based on market cap. Some examples of this would be the S&P 500, S&P MidCap 400, and the Russell 1000 Index. Not only are the companies selected based on their market capitalizations, but the weights assigned to each company also depend on this.

The free float market capitalization is considered to shortlist companies and assign weights. This portion is calculated by multiplying the share price by the outstanding shares held publicly. So, any shares that are held by promoters, insiders, and other entities whose shares are unlikely to be traded are excluded from this calculation.It allows you to understand if a company’s size is being exaggerated or downplayed due to trading activity occurring only in a limited portion of the total outstanding shares. Also, a stock market index that is weighted based on the free float market capitalizations of its constituents will more closely reflect investor sentiments.

Why you should not base all your decisions on market capitalization

As we have discussed throughout this article, investors base their growth and risk expectations on market capitalization. However, you must note this perception is based on various implicit assumptions that may not always be true.

Some of these implicit assumptions could be:

• Companies with larger market capitalizations must have better geographical and product diversification.
• A company that has achieved a large market cap did so through the merit of its management.
• Companies with large market capitalizations cannot grow as fast as smaller companies in the same industry.
• Large-cap companies will find it easier to raise funds from investors and lenders.
• The accuracy of the market cap increases as we move from small-cap companies to large-cap companies.
• A stock with a higher market capitalization is often thought of as more liquid than a stock with a smaller cap.
• Companies with larger market capitalizations have better financial structures and lower exposure to debt risks.
• When a company has a low market cap, it has low brand strength.
• Large-cap companies are presumed to be less prone to price swings and offer more stability.
• Investors are more likely to expect dividends from a large-cap company than a small-cap company.

Thus, market capitalizations can skew investor perception. For instance, Tesla has about $730 billion while The Southern Company is approximately 1/8th of that at about $95 billion. You would expect The Southern Company to have a higher beta, which is a measure of risk and volatility. But, The Southern Company’s beta is 0.37 while Tesla’s beta is 2.58.

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The problem of investor perception and bias leading to sub-par decision-making is even greater in venture capital. This is because startups deal with nascent technologies and new markets and do not have the kind of financial and operational performance data that listed companies can offer. The lack of data and the danger of investor biases are the greatest deterrents to entry in this asset class.

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