When choosing an investment, there are a wide range of figures and numbers you can consider before making a decision. Things can get more complicated when you consider that you, other investors and professionals will put varying levels of emphasis on the factors each deems most important. There is no right or wrong to it. That said, knowing the many statistics and their purpose in investment research can allow you to make more confident and informed decisions.
This article will outline the difference between market cap and the research that dives deeper. More importantly, it will review several research methods that you can put into place to help make the best investment decision for your unique circumstance.
What is Market Cap?
Market cap, or market capitalization, is a very simple formula that tells you the total price of a company’s shares on the market. To see market cap, all you have to do is multiply the total number of outstanding shares that a company has issued by the price of a single share. For example, a company with 100 shares at $100 per share would have a market cap of $10,000.
Market cap can help clearly show you which companies are among the biggest in their industry. While having a significant market cap can indicate a company is successful, it is not a guarantee of future success. With that said, there is an argument to be made that strong companies today are better suited to grow in the future and weather market downturns.
What Does Market Cap Tell You?
Market capitalization is what is often used to define blue chip stocks from small cap stocks. Blue chip stocks are stocks of companies that are seen to be leaders in their industry. These stocks are often more expensive than others and their market cap exceeds the $5 billion mark. In many cases, blue chip stocks pay out dividends, although that is not a guarantee. Overall, people look to blue chip stocks for stability, dividend payments and name recognition. These stocks can be a strong part of your equity portfolio.
On the other side of things are small cap stocks. These stocks have less than $5 billion market capitalization. You might seek out promising small cap stocks with room to grow. These stocks will have lower prices than their competition and, therefore, investors can take a bigger stake in the company with their investment. If the small cap stock price rises as predicted then you stands to gain on the investment. In many cases, small cap companies are focused on growth and don’t typically pay out dividends. These stocks can also be more volatile as they fight for market share against companies that may be much larger and more established than them.
(To learn about the details of what defines a ‘large cap’ or ‘small cap’ stock and see a few examples, take a look at our post from last spring on the topic: What’s the Difference between Small, Mid and Large Cap Stocks?)
What Doesn’t Market Cap Tell You?
While market cap can be helpful for getting some basic information about a company and its performance, there is a lot of information that is not addressed by market cap alone. For example, market capitalization does not indicate the true value of a company. Still, market cap and market value are terms that are often confused.
As mentioned, market cap simply takes into account the number of outstanding shares and the price of an individual share. It does not take into account other aspects that determine the actual value of a company like debt, income, losses and other factors. While market cap and actual value sometimes do fall in line, there are many cases where market cap may not be reflective of a company’s true current value.
One example of this would be with a growth company that is rapidly expanding. These companies could have large, rapidly growing market caps but, operationally, be running at a loss as they take on debt to finance their growth. This is not necessarily a bad thing. If a company can take on debt in the short term in order to grow into a stable, profitable business then that debt may be a good investment. In this case, market cap may be high but the actual value may be low. This is also a good example of a large cap company that does not pay out dividends as there would not actually be any profits from which to pay the dividends.
Market cap also does not make any promises about future stability or profitability of a company. A business with a large market cap may be strong now but this does not guarantee those results will continue. There are countless examples of companies with a very high market cap that have fallen behind the competition to become small cap stocks or go out of business entirely. This is why it’s not a good idea to rely solely on market cap as a method for determining your investments.
What is Value Investing?
One method of research that is used perhaps most famously by Warren Buffett is value investing. This looks beyond market cap and goes deeper into the true value of a company to determine whether the company’s stock can be purchased at a good value currently. Buffett uses a number of different metrics to determine the value of a company when he is deciding whether or not to invest.
His value investing principles look at aspects of a company like net profit after taxes, management abilities, future earnings projections and more. As you may suspect, these methods of researching a business can be very complicated and time consuming. In order to come to a conclusion, you may even have to look beyond the company in question and consider things like market trends, industry competition and more.
Top-Down or Bottom-Up?
Many investors will use a top-down or bottom-up approach when doing investment research. These are two very different styles of research but they can be used in combination with each other in some cases. Top-down investment research considers larger market forces at play when researching investment options. For example, you may consider market trends, current economic climate and future political decisions when taking a top-down research approach. How will these factors contribute to the success (or lack thereof) of a company or industry? In many cases, top-down investors may choose to invest more broadly in specific industries or areas of the economy as they may feel that the market as a whole is set to grow. This is in contrast to trying to identify individual winners and losers.
On the other hand, bottom-up investment research looks more at individual company metrics to determine if an investment is going to be strong. If you were using this approach, you would analyze a single business with the mindset that strong companies can overcome market forces over time. For example, if you identify a promising energy company to invest in then you may be willing to ignore market forces like decreasing oil prices because you believe strongly in the company in question rather than the larger market forces at play. This method of investment research uses many of the same tenets as value investing as it looks for individual companies that are set to perform strongly.
Technical Research for Investors
Technical research is a type of research that focuses on investment charts rather than other fundamentals that have been discussed above. For some of you, technical research is an important part of your overall plan while others may not use technical research at all.
When incorporating technical research, you look for patterns in investment performance charts over a period of time. You may look for support levels where you feel a company’s stock price has buying support and will not go lower. Some patterns even have names like a head and shoulders pattern which can give investors an idea about how a stock will behave based on its response to the pattern.
Ultimately, technical research is an analysis of the behavior of buyers and sellers in the market. Some investors believe that others will behave predictably while others like to use the old investment phrase, “The market can remain irrational longer than you can remain solvent.” Like many methods outlined in this article, technical research is not inherently good or bad. It is simply another tool to use when looking at investment options you are considering adding to your portfolio.
Research and Make the Right Decisions
Market cap, market value and research are three things that can go hand-in-hand. Market cap and market value give a good overall view of an investment but it does not tell the full story . Combining these figures with deeper research is the key to making the right investment choices. It’s also important to keep your own goals and timelines in mind when doing this type of research. Not all investors are the same and staying true to your plan is the most important part of choosing any investment.
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