Market capitalization and price-to-earnings ratio describe the size and relative valuation of stocks, respectively. These measures are important because they can affect portfolio returns. Some investors invest only in small but growing companies, while others favor stocks of established companies that have low P/E ratios. You can screen for stocks based on market cap, P/E and other ratios at online websites, such as Finviz.com and Yahoo! Finance.
Market capitalization is the product of share price and the number of outstanding shares. For example, if a company has 1 million shares outstanding and its stock is trading at $20, its market cap is $20 million. P/E ratio is the ratio of share price to net income or earnings, which is what remains from revenues after paying all expenses and dividends to preferred shareholders. In the example, if the company earns $2 per share, the P/E ratio is $20 divided by $2, or 10. The P/E ratio is also the market cap divided by the total annual earnings, which gives you the same result.
Small-cap, mid-cap and large-cap are the most common stock classifications by market cap. Small-cap stocks are usually under $1 billion in market cap, mid caps are between $1 billion and $8 billion, while large caps are more than $8 billion. According to a summary table on the Fidelity website, small- and large-cap stocks are usually among the best or worst market performers, with mid-caps usually in the middle. Mid-caps are companies that have an operating history, reasonably strong cash flow and moderate earnings growth. Small-cap stocks, which are new and rapidly-growing companies, tend to be more volatile than large-cap stocks, which are usually established companies with diversified products and global operations.
P/E ratios use trailing or forward earnings. The P/E ratio in company reports and financial websites is usually the trailing P/E ratio, which uses the earnings for the most recent 12-month period. Forward P/E ratios use analysts' earnings estimates for the next 12 months. The forward P/E ratio is generally more useful because stock markets tend to look ahead. Investors tend to assign higher-than-average P/E multiples to companies with strong growth prospects. However, stocks with high P/E ratios are also susceptible to sharp corrections if they fail to meet earnings expectations.
Research has shown that small-cap stocks tend to generate a higher return on investment than large-cap stocks. This makes intuitive sense because small companies usually grow from a smaller revenue and profit base, which makes the growth rates higher. The returns for larger companies are more modest because they tend to have a dominant position in most of their major markets and have little room to grow. However, these companies tend to have strong cash flows, which they can use to make strategic acquisitions, repurchase shares or pay dividends to shareholders.