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Small cap

Small cap is an investing term it pays to know. Here’s what it means.

What is small cap?

Small cap is an investing term used to classify companies with a market capitalization between $300 million and $2 billion.

Deeper definition

A company’s market capitalization is determined by the value of its outstanding shares. Multiplying the company’s current share price by its outstanding shares equals its market capitalization.

One of the biggest benefits of small-cap stocks is the advantage they offer individual investors compared with institutional investors. Because mutual funds have such large portfolios, they need to invest large blocks of money to meaningfully impact their portfolio. Small-cap companies have fewer outstanding shares than large-cap companies. When mutual funds initiate the purchase of a large percentage of a small-cap company’s stock, this often triggers SEC filings, which becomes public record. When the public learns about the mutual fund’s intention to purchase the stock, more people buy the stocks, making the stock less attractive to the mutual fund.

Small-cap stocks offer a high risk/high reward profile. It’s much easier for small-cap stocks to increase their profits at a higher rate than large-cap companies. While these stocks have historically outperformed large-cap stocks, small-cap stocks can be more volatile and often lack the economic resources to endure downturns. Because small-cap stocks have fewer shares in the market, price movements can sometimes be exaggerated compared with large-cap stocks. Small-cap stocks may appeal to investors who have a higher tolerance for volatility.

Example of small cap

A corporation that produces virtual reality equipment has 30 million outstanding shares and the current share price is $41 per share. Therefore, its market capitalization is $1.23 billion. Most brokerages would consider the company a small-cap corporation. Because this small-cap company is still relatively small, it has the potential to increase its earnings per share at a much faster rate than its large-cap competitors. However, it also has less cash than its large-cap competitors to get through difficult times.

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