Downside of the Use of market capitalization in stocks screening.

To screen stocks for shariah compliance, an investor will need to conduct a qualitative and quantitative analysis of listed stocks.

In qualitative analysis: stocks of entities that engage primarily in alcohol, gambling, interest, adult entertainment, weapon, tobacco etc. are screened out.

Next is to screen qualified entities quantitatively.

These entities are screened for Debt, Liquidity, Receivables, and interest income.

Debt Ratio: Total interest-bearing debt/total asset or market capitalization. Must be less than 33%

Liquidity Ratio: Cash and Interest-bearing securities/total asset or market capitalization. Must be less than 33%

Receivables: Receivables/market capitalization or total asset. Must be less than 33%

Interest income: Interest income/total revenue. Must not be higher than 5%.

An investor has the choice of using total asset, which is the book value in the company’s balance sheet, or market value as given by market capitalization (widely used) being the share price multiplied by number of shares in issue.

Interestingly, the value of total asset and market capitalization is always not the same. In fact, market value of an entity is mostly higher than its book value as share price is driven by many factors aside an entity’s financial performance.

Since share price is driven by noise, when an investor uses market capitalization, chances are, entities without much market popularity, may fail the test, while those whose share price might have shoot up will likely pass.

When you buy these stocks, not only will you not be getting value for money, chances are, you may be left with a basket of stocks with no buyer when the market sentiment had died or become the victim of share dilution when the firm decides to issue additional shares.

Hence, the use of either Total asset or market capitalization should be market dependent. If a market is liquid, deep, and price discovery is fast, market capitalization should be used.

In a less liquid and shallow market like that of Nigeria, I will recommend the use of total asset.

Lastly, ensure you run further analysis of the entities management team, analyse the entities’ liquidity, profitability, country’s economic indicators, and determine the intrinsic value of the firms you are interested in.

Further steps have been outlined in my previous post on de-risking risky investments do visit for more.

Invest wisely, do your due diligence thoroughly.