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Small-Cap Stock Explained

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Surprise, surprise: it’s a public company that doesn’t have a large market capitalization.

Market cap is simply a number of shares on the market times share price per share. That way, we get the total equity value of the company.

So small-cap stocks have a smaller market cap than mid-caps and large caps, many of which you find on the S&P 500 and Dow Jones Industrial Average. You can track small-cap stocks on the Russell, 3000, 2,000, and 1,000 indexes.

But why would you be interested in a small-cap company?

Since they’re small, many of them are looking to grow, investing aggressively to capture entire markets that represent an opportunity to grow revenue too much larger totals than what they’re pulling in right now. Often, small-caps can have large growth potential and can provide heft returns. 

This does make them slightly riskier. The pricier a stock is relative to its earnings power, the more volatile it is. And if a company doesn’t reach its growth potential, the stock could fall hard. 

We should point out, over time, small caps have not always outperformed large caps and the S&P 500. 

Learn stocks on an individual basis. Find small-cap stocks you’re confident in.
Also, small-cap companies aren’t usually globally exposed. So when something like a trade war happens, they’re less impacted. They can provide shelter from the trade war.

Another factor to consider? Interest rates.

Let’s say you have a small company looking to grow. In order to grow, it has to invest. In order to invest, it might have to borrow a lot of money (have a lot of debt). Inters rates go up? The company better be executing on its growth trajectory or those higher rates are going to make the debt burden on the company heavier. The company is small. It’s vulnerable to mounting liabilities.

Also, it already has a high cost of capital, which is the rate of return investors demand of the company given how risky the company is. A higher cost of debt equals a higher cost of capital. The higher cost of capital literally makes the cash flows of the company less valuable and brings down the valuation. 

So, what's the point? See the quick video above. 

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