Small-cap investing focuses on companies with smaller market capitalizations than the majority of stocks. Since these companies are worth less than large-cap or mid-cap stocks, they are more volatile and risky. However, they also have a higher potential payout. Therefore, you should continue reading to learn the benefits and drawbacks of investing in small-cap companies, why you should consider them, and whether they are suitable for you in this article.
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What Exactly Is a Small-Cap Stock?
Generally, small-cap stocks are publicly traded corporations with market capitalizations of $300 million to $2 billion. Since these companies share prices can be quite volatile, certain companies in the small-cap universe, or in small-cap indexes, can have market caps that are much larger than this range at any given time. Importantly, small caps include insurance business Genworth Financial Inc., printing and image giant Eastman Kodak Co., and retail pharmacy chain Rite Aid Corp.
Small-cap stocks, by definition, have more opportunities for growth than their larger-cap counterparts. This is because the law of large numbers implies that it becomes more difficult for companies to grow as they grow larger. It is considerably easier for a $1 billion company to become a $2 billion company than it is for a $1 trillion company to double in worth.
The Important Things to Consider When Buying a Small-Cap Stock
While there are much small-cap value and dividend stocks available, the reason to buy small-cap stocks is their potential for growth. The components listed below should be checked.
1. Revenue Growth
Revenue growth is especially essential for small-cap equities. This is because younger companies should be able to outperform larger, more established companies in terms of revenue growth. Thus, if you are looking for a small-cap growth stock, sales growth of more than 20% is preferred. A slowing in the top line can signal that the business is either maturing or failing.
2. Earnings Growth
For small-cap stocks, earnings growth is less essential than revenue growth. However, it is still worth considering. Earnings should grow at least as rapidly as revenue in mature organizations. Small-cap growth stocks may not be profitable, but net income should be increasing to limit losses.
3. Price-to-earnings (P/E) Ratio
This component can be used to determine whether companies having earnings are overpriced or undervalued. A smaller ratio may indicate that a company is a good buy, whereas a higher ratio may indicate that it is overpriced.
4. Price-to-sales (P/S) Ratio
The P/S ratio is calculated by dividing a company’s market capitalization by its revenue. It can be a useful component for companies that do not have earnings. Nevertheless, lower ratios often indicate that a company is undervalued in comparison. Additionally, since price-to-sales ratios vary greatly from industry to industry, making apples-to-apples comparisons is critical.
5. Total Addressable Market (TAM)
As you are seeking small-cap stocks with the potential to grow into large-cap stocks, you should assess the scale of the opportunity the company is pursuing. Moreover, you should consider whether this company is attempting to disrupt a market worth tens or possibly hundreds of billions of dollars. Importantly, a huge TAM combined with rapid revenue growth can be a particularly profitable combination for a small-cap stock.
Optionality refers to a company’s ability to enter new business lines. One example is Amazon’s move into cloud computing. It can be difficult to determine a company’s optionality, but a glance at its operational history and industry can provide some insights.
Should You Invest in Small-Cap Stocks?
Small-cap investing, when compared to larger stocks, carries higher risks, but also higher potential returns. As a result, you should consider your risk tolerance and time horizon. Younger investors who want to hold stocks for decades are better suited to small-cap investing than retirees who rely solely on dividend income. Besides, you should purchase a few small-cap stocks. If just one of these stocks takes off, it has the potential to alter your wealth or compensate for dozens of poor investments.
Small-cap stocks can provide excellent growth prospects, but investors should be mindful of the hazards connected with these companies. For starters, they are more volatile. Therefore, it means that price fluctuations and drawdowns can be greater than in stocks of larger corporations. These shares may be less liquid and thinly traded, with wider bid-ask spreads, making it more expensive to enter and exit positions.
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