Reasons for Premiums on Small-Cap Stocks
- A stock's market cap is determined by multiplying its current price by the number of shares outstanding. Small-cap stocks generally have a market cap under $2 billion, so XYZ trading at $5 per share, with 100 million shares outstanding, has the same market cap as ABC trading at $50 per share, with 10 million shares outstanding. To determine which one of the two has a premium, or which one has a larger premium, investors look at the Price-to-Earnings ratios. P/E is the current stock price divided by the earnings per share; the higher the P/E, the more expensive a stock is considered to be. If both XYZ and ABC have an earnings growth rate of 30, but XYZ has a P/E of 100 and ABC has a P/E of 50, XYZ commands a larger premium, although it trades at just $5 per share.
- Since most small caps generally have fewer shares outstanding than their larger peers, premiums often result from too many investors chasing too few shares. It is easier for short-term traders to run up a stock with 10 million shares outstanding than one with one or 10 billion shares outstanding which enjoys more support from large institutional investors. Some "hot" small cap stocks have parabolic rises and then crash just as spectacularly as investors alternately run up and sell small-cap shares, so their premiums can skyrocket and vanish very rapidly.
- Many small-cap stocks grow faster than their larger-cap peers. Investors are willing to pay more for faster growing companies. It is easier for a company to increase its sales from $10 to $100 million than from $100 to $1 billion. The larger a company gets, the harder it is to grow sales at the same pace. As growth slows, the premium shrinks.
- Historically, small- and large-cap stocks take turns outperforming each other. When small-cap stocks outperform, investor demand for them increases, mutual funds start rolling out new small-cap growth funds, and the increased demand lifts the small caps' premium over the large caps.
