What is a Small-Cap Stock?

Small-cap stock refers to a company with a market capitalization (calculated by taking a firm's current share price and multiplying that figure by the total number of shares outstanding) near the low end of the publicly traded spectrum. The boundaries that separate these classifications are not clearly defined and can vary according to the source. Generally, though, the term 'small-cap' is used to describe companies with market values between $300 million and $2 billion.

How Does a Small-Cap Stock Work?

Let's assume Company XYZ currently trades at $50 per share and has a total of 10 million shares outstanding.

Market Capitalization = Number of Shares Outstanding x Current Share Price

Therefore, Company XYZ's market cap would be:

10,000,000 x $50/share = $500 million

By most standards, with a market cap of just $500 million, XYZ would widely be considered a small-cap company. Note, though, that despite the company's small size, its share price is not particularly low. Contrary to what some mistakenly assume, not all small-cap companies have low stock prices. Nor is it appropriate to automatically assume that those with high prices will always be large-cap firms. Stock prices by themselves reveal little about the size of a company, which is why market capitalization is such a widely used measure.

Why Does a Small-Cap Stock Matter?

Most companies, including global giants like Wal-Mart, had humble beginnings as relatively unknown small-cap companies. Although we would all like to find future leaders when they are still trading in the small-cap range, investing in this segment of the market is fraught with risks. Generally speaking, with respect to larger firms, smaller companies are not as financially stable, lack the resources to easily weather economic downturns, and are more likely to have limited or unproven product lines -- all of which lead to increased volatility. With fewer shares changing hands daily (known as trading volume) price movements in less-appraisal4 small-caps can sometimes be exaggerated, which also leads to more volatile price swings.

On the other hand, stock prices are -- to a certain extent -- a function of earnings growth, and smaller companies are often able to increase their profits at a faster clip than larger firms. For example, it is much easier for an emerging company with just $10 million in earnings to double to $20 million over a period of time than it is for a well-established firm to double its net income from $20 billion to $40 billion over the same span. Therefore, small-cap stocks have the potential to deliver greater capital appreciation.

While larger companies are usually followed closely by equity research analysts, small companies typically have modest analyst coverage -- or sometimes none at all. With less attention and publicly available financial information, it is much more difficult to conduct a thorough analysis of the market's smallest companies. For this reason, it is more common for small-cap stocks to be inefficiently priced, or not reflective of the underlying firms' intrinsic values. Therefore, the small-cap market is sometimes a fertile ground for finding undervalued stocks.

In short, small-cap stocks have a high risk/reward profile, and may appeal to investors who are willing to withstand extreme volatility in order to potentially capture tremendous capital appreciation. If you're unfamiliar with equity analysis and valuation and not comfortable with selecting individual stocks in this inherently risky sector, yet still want exposure to the upside potential offered by small-caps, then it may be better to invest in a small-cap mutual fund. There are an abundance of professionally managed mutual funds whose sole objective is to invest specifically in a diversified portfolio of attractive small-cap firms. The best proxy to measure the performance of small-cap stocks, and the closest benchmark to judge small-cap funds, is the Russell 2000 Index.