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| Small-Cap Stock |
What it is:
Small-cap is a term that refers to a company with a market capitalization
(calculated by taking a firm's current share price and multiplying that figure
by the total number of shares outstanding) near the low end of the publicly
traded spectrum. Small-cap firms have market values larger than micro-cap
companies, but smaller than those in the mid-cap sector. The boundaries that
separate these classifications are not clearly defined and can vary according to
the source. Generally, though, the term "small-cap" is used to
describe companies with market values between $300 million and $2 billion.
How it Works/Example:
Let's assume Company XYZ currently trades at $50 per share and has a total of
ten million shares outstanding.
Market Capitalization = Number of
Outstanding Shares * Current Share Price
Therefore, Company XYZ's market cap
would be:
10,000,000 * $50/share = $500 million
By most standards, with a market cap of
just $500 million, XYZ would widely be considered a small-cap company. Note,
though, that despite the company's small size, its share price is not
particularly low. Contrary to what some mistakenly assume, not all small-cap
companies have low stock prices. Nor is it appropriate to automatically assume
that those with high prices will always be large-cap firms. Stock prices by
themselves reveal little about the size of a company, which is why market
capitalization is such a widely used measure.
Why it Matters:
Most companies, including global giants like Wal-Mart, had humble beginnings as
relatively unknown small-cap companies. Although we would all like to find
future leaders when they are still trading in the small-cap range, investing in
this segment of the market is fraught with risks. Generally speaking, with
respect to larger firms, smaller companies are not as financially stable, lack
the resources to easily weather economic downturns, and are more likely to have
limited or unproven product lines -- all of which lead to increased volatility.
With fewer shares changing hands daily (known as trading volume) price movements
in less-liquid small-caps can sometimes be exaggerated, which also leads to more
volatile price swings.
On the other hand, stock prices are --
to a certain extent -- a function of earnings growth, and smaller companies are
often able to increase their profits at a faster clip than larger firms. For
example, it is much easier for an emerging company with just $10 million in
earnings to double to $20 million over a period of time than it is for a
well-established firm to double its net income from $20 billion to $40 billion
over the same span. Therefore, small-cap stocks have the potential to deliver
greater capital appreciation.
While larger companies are usually
followed closely by equity research analysts, small companies typically have
modest analyst coverage -- or sometimes none at all. With less attention and
publicly available financial information, it is much more difficult to conduct a
thorough analysis of the market's smallest companies. For this reason, it is
more common for small-cap stocks to be inefficiently priced, or not reflective
of the underlying firms' intrinsic values. Therefore, the small-cap market is
sometimes a fertile ground for finding undervalued stocks.
In short, small-cap stocks have a high
risk/reward profile, and may appeal to investors who are willing withstand
extreme volatility in order to potentially capture tremendous capital
appreciation. If you're unfamiliar with equity analysis and valuation and not
comfortable with selecting individual stocks in this inherently risky sector,
yet still want exposure to the upside potential offered by small-caps, then it
may be better to invest in a small-cap mutual fund. There are an abundance of
professionally managed mutual funds whose sole objective is to invest
specifically in a diversified portfolio of attractive small-cap firms. The best
proxy to measure the performance of small-cap stocks, and the closest benchmark
to judge small-cap funds, is the Russell 2000 Index.
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