USE OF MARKET CAPITALISATION IN VALUING STOCKS

Market Capitalisation (M Cap) of a company is defined as “ the number of outstanding shares multiplied by the market price of each share”. For instance a company having an issued capital consisting of 1,00,000 shares with each share valued at Rs.100 will have a M Cap of Rs.1 Crore. M Cap of a company changes every day with the change in its market price.

Companies in India are classified into three broad categories on basis of their M Cap.

Large cap companies having M Cap of more than 5000 crore.
Mid cap companies having M Cap between 500 to 5000 crore.
Small cap companies having M Cap of less than 500 crore.

Market cap gives the relative size and stability of a company as compared toother companies in the same industry. An investor can give due weightage to the M Cap of a company before judging its potential as an investment candidate. FII’ and other large investors usually favour large cap companies because of the liquidity they provide and their ability to invest large amounts in these companies without causing wide fluctuations in the price.

Another useful indicator in evaluating a company is its M Cap to sales ratio. This ratio indicates what value the market gives a company as a multiple of its sales. Generally 2.5 to 3 times of sales is considered to be fair valuation for a business, depending on what industry it is in and what is its growth rate.

If a company is being valued by the market at extremely low multiples to sales, an investor can use this as a starting point to investigate why. This can be an important clue to discover undervalued companies. If further investigations into the fundamentals do not reveal any significant problems, it can be inferred that the market has not recognized the value of that particular business and it can be considered as an investment candidate. Like all other ratios, M Cap to sales cannot be used in isolation but should be viewed in conjunction with other fundamental parameters and business attributes.

Another useful hint which the M Cap gives us is that it points us towards the untapped potential of a business model which is in the nascent stage in a country and therefore is not making any profits yet, but the same business model has performed well in other countries where it has had time to flourish and realize its potential.

A case in point is DTH services in India, where companies cannot be valued on basis of existing matrices like earnings, cash flow etc. because they are not generating any profits due to huge upfront investments in infrastructure. M Cap can be a useful parameter to value such companies, by taking into account their number of subscribers and checking what capitalization the market has given to companies with similar number of subscribers in developed nations. If there is a significant variation in M caps, such companies can be considered worthy of further investigation.

Serious fundamental investors should therefore look at the M Cap not only from the viewpoint as an indicator of business soundness, but also as a starting point to spot businesses which are being ignored by the market in spite of being strong investment candidates based on other parameters.