I.P.O - Book Building Process

Two of the most popular means to raise money are Initial Public Offer (IPO) and Follow on Public Offer (FPO). During the IPO or FPO, the company offers its shares to the public either at fixed price or offers a price range, so that the investors can decide on the right price.

Public issue of common shares is essentially carried out in two ways.The method of offering shares by providing a price range is called as book building method.
 
Fixed price method, and
Book-building method.

Fixed price issues are issues in which the issuer is allowed to price the shares as he wishes. The basis for the price is explained in an offer document through qualitative and quantitative statements. This offer document is filed with the stock exchanges and the registrar of companies.

Book building refers to the process of generating, capturing, and recording investor demand for shares during an Initial Public Offering (IPO), or other securities during their issuance process, in order to support efficient price discovery.[1]

Book building

Book building is a common practice in developed countries and has recently been making inroads into emerging markets as well. Bids may be submitted on-line, but the book is maintained off-market by the bookrunner and bids are confidential to the bookrunner.

Book-building is actually a process of price discovery method used in public offers. The issuer sets a base price and a band within which the investor is allowed to bid for shares. Take the recent, Yes Bank IPO, the floor price was Rs 38 and the band was from Rs 38 to Rs 45.

In this method, the company doesn't fix up a particular price for the shares, but instead gives a price range, e.g. Rs 80-100.

When bidding for the shares, investors have to decide at which price they would like to bid for the shares, for e.g. Rs 80, Rs 90 or Rs 100. They can bid for the shares at any price within this range.

Based on the demand and supply of the shares, the final price is fixed. The lowest price (Rs 80) is known as the floor price and the highest price (Rs 100) is known as cap price.

The price at which the shares are allotted is known as cut off price. The entire process begins with the selection of the lead manager, an investment banker whose job is to bring the issue to the public.

Both the lead manager and the issuing company fix the price range and the issue size. Next syndicate members are hired to obtain bids from the investors. Normally the issue is kept open for 5 days.

Once the offer period is over, the lead manager and issuing company fix the price at which the shares are sold to the investors. If the issue price is less than the cap price, the investors who bid at the cap price will get a refund and those who bid at the floor price will end up paying the additional money.

For e.g if the cut off in the above example is fixed at Rs 90, those who bid at Rs 80, will have to pay Rs 10 per share and those who bid at Rs 100, will end up getting the refund of Rs 10 per share. Once each investor pays the actual issue price, the shares are allotted.

Usually, the issuer appoints a major investment bank to act as a major securities underwriter or bookrunner. The “book” is the off-market collation of investor demand by the bookrunner and is confidential to the bookrunner, issuer, and underwriter. Where shares are acquired, or transferred via a bookbuild, the transfer occurs off-market, and the transfer is not guaranteed by an exchange’s clearing house. Where an underwriter has been appointed, the underwriter bears the risk of non-payment by an acquirer or non-delivery by the seller.

Book building vs fixed price

The main difference between the book building method and the fixed price method is that in the former, the issue price is not decided initially.

The investors have to bid for the shares within the price range given and based on the demand and supply of the shares, the issue price is fixed. On the other hand, in the fixed price method, the price is decided right at the start.

Investors cannot choose the price, but must buy the shares at the price decided by the company. In the book building method, the demand is known every day during the offer period, but in fixed method, the demand is known only once the issue closes.

Book building vs. Reverse book building

While book building is used to raise capital for the company's business operations, reverse book building is used for buyback of shares from the market. Reverse book building is also a price discovery method, in which the bids are taken from the current investors and the final price is decided on the last day of the offer. Normally the price fixed in reverse book building exceeds the market price.

Book building is the price discovery method in which the investors bid for the shares of the company during IPO/FPO. They are given a price range in which the investors have to bid for the shares.

Depending on the demand and supply of the shares, the issue price is fixed. Those who bid at the price higher than the issue price end up getting refund and those who bid at the price below the issue price end up paying the remaining amount.

Cut-off price

Once the issue period is over and the book has been built, the BRLM along with the issuer arrives at a cut-off price. The cut-off price is the price discovered by the market. It is the price at which the shares are issued to the investors.

Investors bidding at a price below the cut-off price are ignored. So those investors who apply at a price higher than the cut-off price have a higher chance of getting the stock. So the question that arises is: How is the cut-off price fixed?

The cut-off price is arrived at by the method of Dutch auction. In a Dutch auction the price of an item is lowered, until it gets its first bid and then the item is sold at that price.

Let's say a company wants to issue one million shares. The floor price for one share of face value, Rs 10, is Rs 48 and the band is between Rs 48 and Rs 55.

At Rs 55, on the basis of the bids received, the investors are ready to buy 200,000 shares. So the cut-off price cannot be set at Rs 55 as only 200,000 shares will be sold. So as a next step, the price is lowered to Rs 54. At Rs 54, investors are ready to buy 400,000 shares. So if the cut-off price is set at Rs 54, 600,000 shares will be sold. This still leaves 400,000 shares to be sold.

The price is now lowered to Rs 53. At Rs53, investors are ready to buy 400,000 shares. Now if the cut-off price is set at Rs 53, all one million shares will be sold.

Investors who had applied for shares at Rs 55 and Rs 54 will also be issued shares at Rs 53. The extra money paid by these investors while applying will be returned to them.

When companies are on the look out to raise money for their business operations, they use various means for the same.

The investor had to bid for a quantity of shares he wished to subscribe to within this band. The upper price of the band can be a maximum of 1.2 times the floor price.

Every public offer through the book-building process has a book running lead manager (BRLM), a merchant banker, who manages the issue.

Further, an order book, in which the investors can state the quantity of the stock they are willing to buy, at a price within the band, is built. Thus the term 'book-building.'

An issue through the book-building route remains open for a period of 3 to 7 days and can be extended by another three days if the issuer decides to revise the floor price and the band.

Unlike a public issue, the book building route will see minimum number of applications and large order size per application. The price at which new shares are issued is determined after the book is closed at the discretion of the bookrunner in consultation with the issuer. 

Generally, bidding is by invitation only to high-networth clients of the bookrunner and, if any, lead manager, or co-manager. Generally, securities laws require additional disclosure requirements to be met if the issue is to be offered to all investors. Consequently, participation in a book build may be limited to certain classes of investors. If retail clients are invited to bid, retail bidders are generally required to bid at the final price, which is unknown at the time of the bid, due to the impracticability of collecting multiple price point bids from each retail client. 

Although bidding is by invitation, the issuer and bookrunner retain discretion to give some bidders a greater allocation of their bids than other investors. Typically, large institutional bidders receive preference over smaller retail bidders, by receiving a greater allocation as a proportion of their initial bid. All bookbuilding is conducted ‘off-market’ and most stock exchanges have rules that require that on-market trading be halted during the bookbuilding process.

The key differences between acquiring shares via a bookbuild (conducted off-market) and trading (conducted on-market) are: 

1) bids into the book are confidential vs transparent bid and ask prices on a stock exchange; 

2) bidding is by invitation only (only high-networth clients of the book-runner and any co-managers may bid); 

3) the book-runner and the issuer determine the price of the shares to be issued and the allocations of shares between bidders in their absolute discretion; 

4) all shares are issued or transferred at the same price whereas on-market acquisitions provide for a multiple trading prices.

The book-runner collects bids from investors at various prices, between the floor price and the cap price. Bids can be revised by the bidder before the book closes. The process aims at tapping both wholesale and retail investors. The final issue price is not determined until the end of the process when the book has closed. After the close of the book building period, the book runner evaluates the collected bids on the basis of certain evaluation criteria and sets the final issue price.

If demand is high enough, the book can be oversubscribed. In these case the greenshoe option is triggered.
 
Real Life Application
Before Facebook's IPO, the book building process was used to determined how much the stock was worth before it was sold to the public. Morgan Stanley was the lead investor for Facebook's IPO. Initially, the stock was thought to be determined between $28 and $35 a share. The week before the stock was sold, the demand for the stock was sufficient to increase the price between $34 to $38 a share. Once the stock was offered Morgan Stanley tried to prevent the stock from falling below $38 a share in order to prevent the IPO from being considered a failure. Since Facebook stock initially had a high demand, but this demand fell and its price consequently fell it was considered that Facebook was overvalued when it was sold at its initial public offering. [4]

Types of investors

There are three kinds of investors in a book-building issue. The retail individual investor (RII), the non-institutional investor (NII) and the Qualified Institutional Buyers (QIBs).

RII is an investor who applies for stocks for a value of not more than Rs 100,000. Any bid exceeding this amount is considered in the NII category. NIIs are commonly referred to as high net-worth individuals. On the other hand QIBs are institutional investors who posses the expertise and the financial muscle to invest in the securities market.

Mutual funds, financial institutions, scheduled commercial banks, insurance companies, provident funds, state industrial development corporations, et cetera fall under the definition of being a QIB.

Each of these categories is allocated a certain percentage of the total issue. The total allotment to the RII category has to be at least 35% of the total issue. RIIs also have an option of applying at the cut-off price. This option is not available to other classes of investors. NIIs are to be given at least 15% of the total issue.

And the QIBs are to be issued not more than 50% of the total issue. Allotment to RIIs and NIIs is made through a proportionate allotment system. The allotment to the QIBs is at the discretion of the BRLM.

Lately there have been some complaints by the QIBs of BRLMs resorting to favouritism while allocating shares. The Securities and Exchange Board of India (Sebi) is in the process of reviewing this mechanism.

Let's suppose, A Ltd, makes an offer for 200,000 shares. The issue is oversubscribed -- i.e. there is demand for more shares than the issuer plans to issue. Further, a minimum allotment of 100 shares is to be made for every investor.

The cut-off price has been decided and now the allotments are to be made. In the RII category, 1,500 applicants have applied for 100 shares each, i.e. there is a demand for 150,000 shares.

A Ltd plans to issue 35% of the total issue to this category, i.e. 70,000 shares. In the NII category, 200 applicants have applied for 500 shares each, i.e. 100,000 shares. A Ltd plans to issue 15% of the total issue to this category, i.e. 30,000 shares.

The cut-off price has already been decided, so adjusting the quantity remains the only way of reaching the equilibrium. Applying the proportionate allotment system each investor in the RII category will get 46.67 shares [(70,000/ 150,000) x 100)]. But the minimum allotment has to be 100 shares.

So through a lottery, 700 investors are chosen and allotted 100 shares each, making a total of 70,000 shares. In the NII category every investor will get 150 shares [(30,000/100,000) x 500)]. And that is how equilibrium is reached.

I.P.O - Greenshoe Option

When a company goes public, it does so with an initial public offering of stock. Initial Public Offer or IPO is issued for subscription in the primary market by companies to mobilize funds from general public. The offer document associated with each of the issued IPO besides including other essential details entails the 'greenshoe option'.

A greenshoe option is one of several rules regarding an Initial Public Offering (IPO) that helps a company or business to go public. The question now is what are the provisions under this option.

The greenshoe option deals with being able to facilitate a stock value to stabilize price. There are several kinds of greenshoe options that underwriters, the people responsible for bringing the stock offering to market, can use to make sure that the stock is priced correctly.

Investors can buy in at a defined stock price, but they often must hold the stock for a certain amount of time. This is called an IPO lock-up period. The rules of the lock-up period mean that the stock price is not allowed to fluctuate as it generally would on the common market.

The greenshoe option is not named for anything concerning its literal application to an IPO. Greenshoe option also referred to as over-allotment option was termed Greenshoe option as Green Shoe Manufacturing Company now known as Stride-Rite Corp, that pioneered its use, for the first time implemented the greenshoe provision in their IPO underwriting agreement. The option is regulated by Securities and Exchange Board of India (SEBI).Many companies involved in an IPO have since applied a greenshoe option in order to encourage growth during and after an initial public offering. It is a price stabilizing mechanism for maintaining post issue price stability.

A green shoe option is a clause contained in the underwriting agreement of an initial public offering (IPO). Also known as an over-allotment provision, it allows the underwriting syndicate to buy up to an additional 15% of the shares at the offering price if public demand for the shares exceeds expectations and the stock trades above its offering price.

In a greenshoe option, the underwriter can issue up to 15% more stock than the original issued shares if high demand is a problem.

When an issue is oversubscribed then this option can be undertaken to bring stability to the price of a security. Over subscription means there is more demand than supply for the underline security and this mismatch can result in the huge fluctuations to the price of security post listing and in order to bring the confidence and stability to the price additional issued shares are under Green shoe option are supplied in to the market.

According to experts, using additional stock in a short sale can also help stabilize the stock price. What the underwriter does with the extra stock can help create a stock price that will resemble the initial offer price.

Partial, whole, or reverse greenshoe options are useful to those who have to do the work of shoring up the value of an IPO. In addition, other rules often affect an IPO, including a “quiet period,” where staffers of a company or business are prohibited from talking about the value of their stock for a certain amount of time. The Securities and Exchange Commission, the agency in charge of regulating the stock market, sets these rules to limit volatility and promote healthy trading.

The greenshoe option can help underwriters, or “stabilizers” deal with the effects of a red herring prospectus, which is a document issued before all of the fine print on an IPO is set in place. The greenshoe option can also be helpful in a “break issue” situation, where various factors lead to a stock's price sagging lower than the original offer price. Factors in a break issue can include lock of consumer faith in a product, an overall economic downturn, or the spread of rumors about a company.

Let us understand greenshoe option with an example :

In case a company X floats an IPO of issue size of 5 million shares with 10% greenshoe option. And in case it witnesses surge in demand, underwriters to the issue can issue additional 5lakh shares.

Implication of exercise of greenshoe option for investor

The exercise of greenshoe option increases the probability of shares being issued to the investor. Also, the option is likely to result in price stability of the stock post listing on the exchange in comparison to the overall stock market outlook.

Some IPO agreements do not include greenshoe options in their underwriting agreements. This is usually the case when the issuer wants to fund a specific project at a pre-determined cost and does not want to be responsible for more capital than it originally sought.

A green shoe option can create greater profits for both the issuer and the underwriting company if demand is greater than expected. It also facilitates price stability.

I.P.O - Fresh Issue

A stock market is a place where people buy and sell shares where as a new issue market is just a part of the stock market, in the sense that any company which has to raise its money from public has to come out with a public issue only after which that stock can be listed on the stock exchange.

A corporation’s first offering of stock to the public. IPO’s are almost invariably an opportunity for the existing investors and participating venture capitalists to make big profits, since for the first time their shares will be given a market value reflecting expectations for the company’s future growth.

The first time a company issues stock, it's called going public.

Going public, or taking a company public, means making it possible for outside investors to buy the company's stock. To go public, the management registers the stock with the Securities and Exchange Board of India (SEBI) and makes an initial public offering (IPO).

FROM PRIVATE TO PUBLIC OWNERSHIP

The road to public ownership often begins with an entrepreneur who has come up with an idea for a product or service and borrows enough money to launch a start-up business. If the company grows, the entrepreneur may be able to raise funds for expansion in the private equity market.

There, wealthy investors, investment companies, or other groups pool money — called venture capital — that they're willing to risk on a new business in exchange for a role in how the company is run and a share of the potential profits.

GOING PUBLIC

If a small company finds its product or service in great demand, it outstrips the ability of venture capitalists to provide money for rapid growth. That's when it decides to go public.

First, the management goes to investment bankers who agree to underwrite the stock offering — that is, to buy all the public shares at a set price and resell them to the general public, hopefully to great demand.

The underwriters help the company prepare a prospectus, a detailed analysis of the company's financial history, its products or services, and its management's background and experience. The prospectus also assesses the various risks the company faces.

ATTRACTING INVESTORS

The proposed stock sale is publicized in the financial press. The ads are commonly known as tombstones because of their black borders and heavy print.

The underwriters may also organize meetings between the company's management and institutional investors, such as pension or mutual fund managers. The day before the actual sale, underwriters price the issue, or establish the price they will pay for each share.

When the stock begins trading the next day, the price can rise or fall depending on whether investors agree or disagree with the underwriters' valuation of the new company.

SELLING DIRECT

Some companies may make a direct offering to investors, by selling shares in an online auction format. This type of offering may save money by eliminating fees paid to underwriters, and it may result in the issuer making more money from the offering itself. Companies who do an IPO this way still must meet the SEBI's filing rules.

One drawback of direct offerings for small companies is that they aren't followed by market analysts so that there could be limited knowledge about and interest in the offering. But that's not an issue for major companies who choose to go public this way.

When a public company issues new shares, the total number of shares traded in a secondary market goes up. Assuming there is no change in the fundamentals of the company and the profitability, I would expect that the share price of the existing shareholders would fall. However, this does not always happen in real life.

A company can only offer new shares if they have "unissued capital". Unissued capital is only a token restriction. When a company is incorporated a maximum number of shares is specified in the legal documentation. Most companies will make this an extremely large number so they never face that limitation. See here.

You wouldn't necessarily expect the stock price to change. The reason a company issues new stock is as a way to raise capital. Although new stock is issued, the cash raised by the sale becomes an Asset on the company's balance sheet. There's a good worked example in this Wikipedia article.

Following a rights issue the Liabilities of the company will increase to account for the increase in owner's equity, but the Assets will also increase by the same amount with the cash received.

Whether the stock price changes will depend upon what price the stock is issued at and on the market's opinions about the company's growth potential now it has new capital to invest. If the new stock is issued at the same price as the current market price, there's no particular reason to expect the share price to change. Again Wikipedia has more detail.

When new stock is issued it is usually offered to existing shareholders first, in proportion to their current holding. If the shareholder decides to purchase the new stock in full then their position won't be diluted. If they opt not to buy the new stock, they will now own a smaller percentage of the company as their stocks will make up a smaller part of the now larger number of shares.

New share issues via public flotations 
Introduction

There are three main ways of raising equity finance:
- Retaining profits in the business (rather than distributing them to equity shareholders);
- Selling new shares to existing shareholders (a "rights issue")
- Selling new shares to the general public and investing institutions

This revision note outlines the process involved in the third method above.

Methods

The process of a stock market flotation can apply both to private and nationalized share issues. There are also several methods that can be used. These methods are:

• An introduction
• Issue by tender
• Offer for sale
• Placing, and
• A public issue

In practice the “offer for sale” method is the most common method of flotation. There is no restriction on the amount of capital raised by this method.

The general procedures followed by the various methods of flotation are broadly the same. These include
- Advertising, e.g. in newspapers
- Following legal requirements, and Stock Exchange regulations in terms of the large volumes of information which must be provided. Great expense is incurred in providing this information, e.g. lawyers, accountants, other advisors.
  
Why issue new shares on a stock exchange?

The following are reasons why a company may seek a stock market listing:

Access to a wider pool of finance

A stock market listing widens the number of potential investors. It may also improve the company's credit rating, making debt finance easier and cheaper to obtain.

Improved marketability of shares

Shares that are traded on the stock market can be bought and sold in relatively small quantities at any time. Existing investors can easily realise a part of their holding.

Transfer of capital to other uses

Founder owners may wish to liquidate the major part of their holding either for personal reasons or for investment in other new business opportunities.

Enhancement of company image
Quoted companies are commonly believed to be more financially stable. A stock exchange listing may improve the image of the company with its customers and suppliers, allowing it to gain additional business and to improve its buying power.

Facilitation of growth by acquisition

A listed company is in a better position to make a paper offer for a target company than an unlisted one.

However, the owners of a private company which becomes a listed plc (public company) must accept that the change is likely to involve a significant loss of control to a wider circle of investors. The risk of the company being taken over will also increase following listing.

SECONDARY OFFERINGS

If a company has already issued shares, but wants to raise additional capital, or money, through the sale of more stock, the process is called a secondary offering.

Companies are often wary of issuing more stock, since the larger the supply of stock outstanding, the less valuable each previously issued share becomes. That's known as dilution.

For this reason, a company typically issues new shares only if its stock price is high. If it needs money, it may decide instead to issue bonds, or sometimes convertible bonds or preferred shares.

A company gets money from stock sales only when the stocks are issued. All subsequent trading means a profit or loss for the stockholder who sells, but nothing for the company that issued it.

Penny Stocks

Low-priced, small-cap stocks are known as penny stocks. Penny stocks are stocks which have a low value. Penny stocks, also known as cent stocks in some countries, are common shares of small public companies that trade at low prices per share.

Contrary to their name, penny stocks rarely cost a penny. There is no specific price that a penny stock has to be for it labeled a penny stock, however in the UK Penny stocks are often shares with a value between 1p and £1. In the US penny stocks are between 1 cent and $1.

The SEC considers a penny stock to be pretty much anything under $5. And while there are sub $5 stocks trading on big exchanges like NYSE and NASDAQ, most investors don't think of these when asked to describe a penny stock.

The term penny stock does not actually have a strict definition. One of the more common definitions of a penny stock is one which is literally priced in pennies or more specifically with a share price under a dollar. A more common definition however is that a penny stock is any stock which is priced under $5.

Another way that people define whether a company is a penny stock is according to how it is traded. This definition describes penny stocks as being those companies which trade on the over the counter market or the pink sheets. In other words, these are alternates to the traditional stock exchanges such as the NASDAQ or NYSE.

In the United States, the SEC defines a penny stock as a security that trades below $5 per share, is not listed on a national exchange, and fails to meet other specific criteria.[1] In the United Kingdom, stocks priced under £1 are called penny shares. In the case of many penny stocks, low market price inevitably leads to low market capitalization. Such stocks can be highly volatile and subject to manipulation by stock promoters and pump and dump schemes. Such stocks present a high risk for investors, who are often lured by the hope of large and quick profits. Penny stocks in the USA are often traded over-the-counter on the OTC Bulletin Board, or Pink Sheets.[2] In the United States, the Securities and Exchange Commission and the Financial Industry Regulatory Authority (FINRA) have specific rules to define and regulate the sale of penny stocks.

Penny stocks are popular because any increase/decrease in their value results in big profits/losses for the trader.

Example

• a trader invests $10,000 on two different shares, share A @ $40 and share B @$0.75 (penny share).
• share A has a value of $40 and gains 25 cents  (0.625% gain) 0.625% of $10,000 = a profit of $62.50
• share B (our penny stock) has a value of 75 cents and gains 25 cents. A 33.33% gain. A 33.33% gain of $10,000 = a profit of $3,333.33!

This clearly show that profits and losses are far steeper with penny stocks, which can represent an attractive investment for someone who needs quick money. However there are 3 major downsides when trading penny stocks;

• penny stocks lack liquidity and you may not be able to get out of a trade when you want to.
• there are schemes with penny stocks whereby someone (crooked Craig), informs everyone (people with little stock market education), to buy a specific penny share (which he already owns), then sells the penny stock after everyone he has informed to buy it, buys it. This means crooked Craig has made his profits whilst potentially leaving other people in a dangerously volatile trade.
• penny stocks can lose you money as fast as they can help you gain it, however this isn’t so much of a down side as this is the case with all investments.

Most individual investors look at penny stocks like Wall Street's Wild West, an untamed world of investing detached from all the glitz and media coverage that comes with stocks that are traded on major exchanges. While the gains and losses can be pretty impressive in the penny stock world, they're not often heard about elsewhere.
Just because you don't hear about penny stocks every day on CNBC doesn't mean that penny stocks are without drama -- take SCO Group, a software company that brought on the wrath of the world's computer-literati when it made claims to the UNIX operating system. Unfortunately, penny stocks have also garnered a reputation as a game filled with scams and corruption. Indeed, penny stocks could be your wildest ride yet as an investor.

So then, if penny stocks usually aren't traded on normal exchanges, where can you buy them?

Small Cap Stocks

You may have heard the terms small-cap, mid-cap, or large-cap in your reading about stocks and the companies that issue them. The term cap stands for capitalization and refers to the value of a company, which is a measure by which we can classify a company's size too. Big/large caps are companies which have a market cap between 10-200 billion dollars. Mid caps range from 2 billion to 10 billion dollars.

Stock is often classified by small, mid-size, or large company size. Sometimes the stocks of different-sized companies offer investors better opportunities than stock of larger or smaller firms. Understanding stock capitalization will help you make better investment decisions when put into the perspective of the economic climate in which you invest.

These might not be industry leaders but are well on their way to becoming one. Small caps are typically new or relatively young companies and have a market cap between 300 million to 2 billion dollars.

Although their track record won't be as lengthy as that of the mid to mega caps, small caps do present the possibility of greater capital appreciation, but at the cost of greater risk.

Many of us must have got mails with this headline some or the other time. And chances are that many of us must have also checked out which stock this is and invested in it! The first thing that catches our attention here is the word ‘MULTIBAGGER’. Who doesn’t want their money to multiply in a short time? Right? But, while there is a possibility that a few fortunate ones actually earn money from such multi-bagger ideas, there is also a possibility that your investment in the stock may be entirely wiped out.

The reason : Because while focusing on ‘MULTIBAGGER’, we ignored, possibly the more important word, i.e. ‘SMALL-CAP STOCK’!

Believe it or not, but the market capitalization of a stock plays an important role in deciding which stock you invest in. Choosing the best stock based on its market capitalization and your risk profile can help protect your hard-earned money and earn you great returns; more importantly it can prevent the heartburn you will get seeing your money go up in flames! But before we get into how you can do this, let’s first understand the basics of market capitalization.

If you wish to buy a company and all its shares were offered to you at the current market price, how much would the company cost you?

The answer is its Market Capitalization. Yes, you will have to pay the “Market Capitalization” of the company which is the product of a company’s total number of shares outstanding and the market price of the share i.e.

Let’s understand it with the help of an example. Suppose, you decided to purchase ABC Industries on New Year, when its shares were trading at Rs.50 and the number of shares outstanding were 1 crore. You would have paid,

Rs.50 x 1,00,00,000 = Rs. 50,00,00,000
i.e., Rs. 50 Cr. is the Market Capitalization of ABC Industries.

However, what you should remember is that the market price of a share is the public opinion about the worth of a company’s stock. Thus, Market Capitalization is the public opinion of what the whole company is worth. This opinion is based on the past performance, future prospects and market sentiments of the public about the company. The market capitalization changes with time as a result of factors like company performance, economic factors like inflation, interest rates, etc. In India, you can find companies with market capitalization ranging from a few lakh to as much as few lakh crores! As a result, companies are usually classified as large-cap, mid-cap and small-cap companies. This brings us to the next question.
 
What are Large-cap, mid-cap and small-cap companies?

We have frequently heard about some companies being Large-cap (For e.g. Reliance, Infosys etc.) while others being Midcap or Small-cap companies. Wonder how they are classified? Let’s take a look at how the BSE classifies companies according to their market capitalization.
So, what is the difference between these categories?

Market capitalization is regarded as an indicator of a company’s size. Large-cap companies are more robust. A large-cap company can be compared to a heavy goods carrier, while a midcap company to a mini carrier. If there is a speed breaker/bump on the road, the chances of a mini carrier getting knocked down are much more as compared to the heavy goods carrier. At the same time, a mini carrier picks up speed quickly and travels faster as compared to the heavy goods carrier; which requires time to catch up speed but has better stability and momentum. Given below is a comparative account of Large-cap, mid-cap and small-cap companies.

So, why should you as an investor look at a company’s market capitalization?

Let’s have a look at the Investor Meet where three good friends – Mr. Conservative, Mr. Practical and Mr. Adventurous are having dinner together:

What did u observe in the above picture?

Mr. Conservative has a very low risk appetite, so he wants to be safe and invests only in large-cap stocks.

Mr. Practical understands that if he wants high returns he must take high risk. So, he invests a part of his funds in Mid-cap stocks which increases his chance of getting a high return on his total investment. At the same time, he keeps a large part of his investment exposed to low risk by investing in large-cap stocks.

Mr. Adventurous, on the other hand, is willing to risk losing a large part of his investment, for the possibility of getting very high returns on his investments. So, he invests most of his funds in risky mid-cap and highly risky small-cap stocks; he keeps a very small part of his fund invested in large cap stocks.

Thus, market capitalization plays an important role in deciding which companies you should invest in considering your expected returns and your risk appetite.
So, what kind of a person are you? Are you Mr. Conservative, Mr. Practical or Mr. Adventurous?