Small cap stocks are a company with a market capitalization within the range of $250 million to $ 2 billion. Over the past few decades, small cap stocks have received a lot of negativity. This is attributed to the media focus on the negative side of small cap stocks.
Basically, the media has highlighted frequently how risky these financial instruments are. While this may be from valid concerns, majority of companies that are regarded as valuable today like Wal–Mart started out as small cap stocks. Small cap stocks can be traded at the NASDAQ or the OTCBB since they have more lenient listing requirements.
In trading, it is very important not to confuse small cap stocks with penny stocks. Two major differences between small cap stocks and penny stocks have been identified.
Small cap stocks are based on market capitalization of the company and not the stock price while penny stocks are known to trade at low prices and market capitalization.
Also, small cap stocks trade higher than $5 while penny stocks trade below $5. As a result, penny stocks are regarded as high risk investments due to their lack of liquidity, low price and wide bid-ask spread. Furthermore, they don’t trade on major exchanges like NYSE and NASDAQ.
How to calculate market capitalization
Market capitalization simply refers to the market value of a company’s outstanding shares. Calculating market capitalization is quite simple. You need the following variables:
i. Current share price
ii. Number of outstanding shares
Here is the formula:
Market capitalization = (current share price multiplied by number of outstanding shares)
Let’s assume Company X has 35.65 million outstanding shares. The current price for each share is $15.15. To calculate market capitalization, you simply multiply the above variables as depicted in the example below
($15.15 X 35.65 million outstanding shares)= approx. $ 540 million.
Since the above figure is between $250 million and $2 billion, Company X is classified as a small cap company as of 2017.
Pros of small cap stocks
i. Higher growth potential
As said earlier, majority of successful companies for example Wal-Mart started out as small caps. By investing in small caps, you have the chance of growing your investment. This is because small caps have the opportunity of growing and expanding rapidly which is not the same for large companies.
ii. An opportunity to profit
By now, you already know that small cap stocks receive little or no attention from Wall Street. As a result, it is advantageous to an individual investor. How? Small caps usually go under – reported and because of this, they are not priced properly. If the company is offering life changing products and services like AI, robotics or a wonder cure, within a few years, your small invest will have grown extravagantly resulting in higher profits to you.
iii. Early bird investment opportunity
As an individual investor with a keen eye of spotting promising companies, you have an early opportunity of investing in the company before institutional investors do. When they do, they will end up purchasing more shares finally pushing the share price higher. In the end, your investments will have a higher value.
Drawbacks of small cap stocks
i. Risky investment
While small cap stocks have the opportunity of growing thanks to improved sales, they may not have the same success experienced by US retail giant, Wal-Mart. The reason why small cap stocks are risky investments is because they are susceptible to volatility as a result of their market capitalization. This means there is less volume to move prices.
ii. Time consuming
Spotting a promising small cap stock is not as easy as you think. One must be prepared to conduct a lot of research which is definitely time consuming. The reason for this is that financial ratios and growth rates for small companies are not published like they do for large companies. Furthermore, there are less analyst reports available.
While small cap stocks may not replicate the success of Wal-Mart, they are still appealing to individual investors who are able to withstand extreme volatility. Despite this, if you are not familiar with equity analysis and valuation, then its best to seek another form of investment for example small cap mutual fund.