Market Cap Explained: It's the Single Number I Check Before Buying Any Stock

The market cap reflects the total dollar value of a publicly traded company's outstanding shares. If a company has 1 billion shares at $8 per share, it has an $8 billion market cap.

I look at this number before buying any stock because it highlights an investment's growth potential. While market cap isn't the only thing to consider, it's a critical part of my stock analyses. Here's why I put so much value into this number.

Image source: Getty Images.

The different types of market caps

A $5 trillion company is a bit different from a $500 million company, and that's why investors use multiple categories to describe stocks by market cap. Here's the brief summary:

• Micro-cap stocks: Market cap under $300 million
• Small-cap stocks: Market cap between $300 million and $2 billion
• Mid-cap stocks: Market cap between $2 billion and $10 billion
• Large-cap stocks: Market cap between $10 billion and $200 billion
• Mega-cap stocks: Market cap above $200 billion

Smaller companies are riskier but have a higher potential upside, while large-cap and mega-cap stocks are treated as more mature companies. They have a lower potential upside, but they also have less risk.

Large-cap and mega-cap stocks can still outperform smaller companies. Mega-cap stock Nvidia (NASDAQ: NVDA) is up by more than 20% year to date, easily outperforming the S&P 500 and most small companies.

However, I usually stay away from large-cap and mega-cap stocks. Some micro-cap stocks are in my portfolio, but my sweet spot is small-cap and mid-cap stocks.

Finding the next Nvidia requires understanding market caps

Many investors wish they could find the next Nvidia. Some people actively search for those types of growth stocks, while others read articles that explain why a certain stock can become the next Nvidia.

In most cases, this means looking for a stock that can deliver a 10x return, and for that, you have to focus on smaller companies.

Micron (NASDAQ: MU) has become a large player in the AI trade as its memory chips continue to fly off the shelves. However, Micron also has a $1.2 trillion market cap. The company would have to reach a $12 trillion market cap, more than twice Nvidia's current valuation, to produce a 10x return.

It's much easier for a $2 billion company to become a $20 billion company than it is for a $1.2 trillion company to soon command a $12 trillion valuation. That's why my memory plays are Penguin Solutions (NASDAQ: PENG) and Netlist (OTC: NLST) instead of Micron. Both of these companies have market caps under $5 billion and have more than doubled their memory revenue year over year.

A low market cap does not guarantee better returns

I'm not just buying more shares of Penguin Solutions and Netlist because I like their market caps. I primarily build these positions because of good fundamentals. They are exposed to the growing memory chip industry and have attractive multiyear tailwinds.

A market cap under $10 billion serves as an invitation for me to do more digging. Then I review earnings reports and presentations to assess the company's current direction.

Most stocks underperform the broader market, and that's especially true for smaller companies. The Russell 2000 Index, the small-cap benchmark, is up by less than 30% over the past five years. The S&P 500 has gained more than 70% over that same stretch.

Ironically, the Russell 2000 Index is a great place to find smaller companies that can crush the giants. However, this benchmark is filled with too many small-cap companies, which minimizes the impact of 10x performers. For instance, the benchmark's largest holding makes up less than 0.5% of the entire fund.

Companies with smaller market caps are more volatile and can result in significant capital losses for some positions. However, a single small-cap stock that can 10x will undo the losses of smaller positions. Prioritizing companies with smaller market caps increases the likelihood of compelling returns, but it's an opportunity only suitable for investors who can stay on top of their investments and read the news every day to learn new things.

Marc Guberti has positions in Netlist and Penguin Solutions. The Motley Fool has positions in and recommends Micron Technology, Nvidia, and Penguin Solutions. The Motley Fool has a disclosure policy.