Topic: How To Invest

Investor Toolkit: How market cap can make a difference in your stock picks

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Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a new or experienced investor, these weekly updates are designed to give you specific investment advice that will help you develop a successful approach to investing. Each Investor Toolkit update gives you a fundamental tip and shows you how you can put it into practice right away.

Today’s tip: “While many numbers and statistics frequently prove to be of limited value in judging stocks, there is one that is often undervalued: market cap.”

We always look at much more information than we include in our analyses and reports. Our aim is to strike a balance with the information we provide. We want to include any added data that might be helpful, but we want to avoid flooding investors with statistics that might just clutter things up.

A big part of our job is to sift through the overwhelming volume of information that’s available today, and only pass along the part that you might want or need to know.

Take two statistics that we apply to the stocks we analyze. There are listed with every stock we cover in our publications: the number of shares the company has outstanding, and the “market cap” (the market capitalization, or the number of shares times current price per share).

Market cap says a great deal about a company. A company’s market cap can grow even while its stock price falls, if it issues new shares.

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When ignoring market cap led to huge losses

A classic case of ignoring a key statistic occurred during the Internet boom of the late 1990s. Many investors dismissed the importance of market cap, and wound up with huge losses. They got caught up in the ingenious business concepts that Internet entrepreneurs were coming up with in those days. They forgot that even the best businesses need time to reach profitability, and that every successful business attracts competition. If they had considered market cap as we did, they would have spotted the root of the Internet bust of the early 2000s.

Back then, many Internet startups that barely had sales, let alone earnings, were trading at market caps of one billion dollars and up. They needed vast overnight success to justify their current prices, let alone go higher.

The same caution applies to startup companies, in technology or other industries. If a startup company already has a high market cap—$100 million, say—it may need great success to justify its current stock price, let alone move up.

If a company’s market cap is close to or less than its total yearly sales, this may indicate that it offers substantial value. However, companies in businesses with low profit margins, such as food retailers, ordinarily have a market cap that is a fraction of their sales. That’s because they earn modest profit margins, perhaps a few pennies on each dollar of sales.

When a stock trades at a high ratio of market-cap-to-sales—over 5.0-to-1.0, for instance—it usually means it’s in a highly profitable business, or else investors have bid up the price of its shares because they have high expectations for future growth. This introduces an element of risk.

A high market-cap-to-sales ratio makes a stock sharply vulnerable in a market setback. If its profit falls or if it fails to live up to investor expectations, its stock price can plummet. It’s best to avoid over-loading your portfolio with stocks that have a high market-cap-to-sales ratio.

COMMENTS PLEASE—Share your investment experience and opinions with fellow members

The crash of Internet stocks in the early 2000s turned some investors away from tech stocks altogether. When the bottom falls out of a group of stocks in an industry or a commodity, do you avoid investing in those stocks? Or do you buy stocks at “distressed” prices? If so, are there particular indicators you use to pick the stocks you think will rebound best?

Note: This article was initially published on September 5, 2012.


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