Question

1. How does the size of a firm as measured by market capitalization tend to affect its required rate of return? What is the historical return on categories of investment – large cap, mid-cap, small cap – and how can this affect investment strategies?

Answer 1

The size of a firm as measured by market capitalization tend to affect its required rate of return

Market value of equity is the total dollar value of a company's equity calculated by multiplying the current stock price by total outstanding shares. A company's market value of equity is therefore always changing as these two input variables change. Market value of equity is a synonym for market capitalization. It is used to measure a company's size and helps investors diversify their investments across companies of different sizes and different levels of risk.

Generally speaking, the investment community uses market cap as a viable way to determine a company’s size. Indeed, the stock price is a core part of the market cap calculation to begin with. Market cap is determined by taking the number of a company’s shares and multiplying that by the current price of one share.

A lot of people say that market cap is the value of the business. In fact, that is so commonly done that professors at some of the best universities in the country have made this mistake over and over again by assuming that what the market price is of a business is what the business is worth.

Remember that market cap is a reflection of what we would pay today to own a piece of the company. But this price is not the true value of the business. If we make market cap the only metric to determine whether or not we invest, we are letting the market .

Smaller businesses will float smaller offerings of shares. So, these stocks may be thinly traded and could take longer for transactions to finalize. However, the small cap marketplace is one place where the individual investor has an advantage over institutional investors. Since they buy large block purchases of stocks, institutional investors do not involve themselves as frequently in small cap offerings. If they did, they would find themselves owing controlling portions of these smaller businesses.