A Markov Model for Stocks with Small and Medium

Market Capitalization
Dr. Pavel Dubovski, Irina Goldman, and Dr. Fotios Harmantzis1

Stevens Institute of Technology

Abstract

We developed a Markov process to model market capitalization, and hence, the stock price of a
publicly traded company. We prove that the stochastic process leads to a linear dependence of
the log of the market capitalization against the company’s size rank. To estimate the parameters
of the birth-death process, we calibrated our model to US companies tracked by popular indices,
at different cycles of the economy, e.g., boom vs. recession. We provide a numerical example,
where our theoretical results perfectly correspond to 90% of the observations of the Russell 2500
universe (10% smallest companies were excluded). The approach, since it models the size distri-
bution of a universe of stocks, can be used as a trading strategy betting on stock prices, hence,
future returns.
Key words: Asset pricing, Firm Size, Market Capitalization, Markov Processes, Birth-Death
Processes, Regression
JEL classification: G12, G14

1. INTRODUCTION

The problem of modeling and predicting stock prices is fundamental in asset pricing theory.
Empiricists as well as academics believe that there is information in the distribution of the
market capitalization, i.e., size, of a firm that should be exploited for forecasting purposes,
e.g., M. Mauboussin et al. (1999), G. Ip (1999), S.C.Kou and S.G.Kou (2003), S.C.Kou and
S.G.Kou (2004), etc. Evidence of the dependence between market capitalization and the rank
of a company was first reported by equity research analysts at Credit Suisse First Boston (Wall
Street Journal, December 27, 1999): “the pattern emerges when the companies’ values are plotted
along with their market-capitalization rank on a logarithmic chart”. Such “power low”, known as
the Zipf distribution, G. Zipf (1949), has been found and applied in measuring natural and social
phenomena, such as the frequency of word usage, the number of cities of a certain population,
Internet growth, etc.
In their 2003 paper, S.C.Kou and S.G.Kou constructed a mathematical model for growth
stocks via birth-death processes with linear transition intensities. The authors considered as
“growth” firms, firms that pay no dividends, have negative earnings and highly volatile stock
prices. The data sets used include several technology (Internet) as well as bio-technology firms.
Their model leads to a linear dependence between market capitalization of firms and their relative
rank on the log-log scale (on the standard scale this is a power dependence). They argue that
such a phenomenon should not be expected for non-growth stocks.
Motivated by the Kou-Kou model, we construct a similar birth-death process for stocks in
a broader investment universe, i.e., a more general model. First, we confirmed that for the
data sets used in the Kou-Kou 2003 paper power low is really valid; however, for all other
companies we observed a different pattern. In this paper we show that “non-growth” stocks can
be also modeled via birth-death processes and, unlike the case in S.C.Kou and S.G.Kou (2003),
there is a linear dependence between the logarithm of market capitalization of stocks and their
1 Corresponding author: Email: fharmant@stevens.edu

1
rank. Actually, linear dependence on the log-standard scale, manifests exponential dependence
between the two variables, i.e., market capitalization and rank. In order to demonstrate that
our theoretical results can be applied to market data, we calibrated our model to a broad US
index, e.g., Russell 2500. For most of the stocks in that index, we confirmed a linear dependence
between the logarithm of the market capitalization and the rank of small and mid-caps, i.e., 90%
of the companies at Russell 2500. For companies with large capitalization, (that can be included
in more general indices, e.g., Russell 3000), our nonlinear transition rates tend to the linear rates
introduced by Kou-Kou, i.e., evidence of power-low.
Having calibrated the model parameters to a universe of stocks, as presented via numerical
examples in this paper, a market speculator has established a linear relationship between a
company’s rank in the universe, e.g., companies participating in an index, or sector, and its
market capitalization. Given the fact that the number of total common shares outstanding does
not change frequently, once can use the model to predict stock prices.
The paper is organized as follows: Section 2 proposes a new stochastic mathematical model
for firm size (equity market value). Preliminary numerical illustrations, which confirm the theo-
retical results, are presented in Section 3. The summary and concluding remarks can be found
in the last section.

2. MATHEMATICAL MODEL

Our aim is to model the size of the constituents of a broad index, e.g., Russell 2500. A similar
model was proposed in (S.C.Kou and S.G.Kou (2003)) for “growth” stocks, i.e., Internet and
bio-technology firms with negative earnings and highly volatile stock prices. The main difference
in our model compared to the one by S.C.Kou and S.G.Kou (2003), is that our model’s “death”
rates are higher.
Let us denote the total market capitalization by M (t). Let the birth-death rates be
λi = iλ + g, i ≥ 0, µi = (iµ + h)e1/(i+α) , i ≥ 1.
These rates correspond to the change of market capitalization i measured in relative units (say,
in millions of dollars). The rates λi and µi describe the rates of increase or decrease, respectively.

Remark. For large values i, which correspond to large market capitalizations, e1/(i+α) ≈ 1 and
the transition rates µi ≈ iµ + h become almost linear. In the suggested model, the exponential
term e1/(i+α) in the “death” rates µi is lower for companies with larger market capitalization,
compared to the death rates of companies with smaller market capitalizations. Therefore, the
model is appropriate for a universe of stocks where the largest companies retain their rankings
over time.

Let N be the number of stocks in our universe (N is a relatively large number, e.g., number
of stocks in a broad index). For large N , the steady-state distribution can be approximated as
(Karlin, 1968)
λ0 λ1 · λn−1
π0 = 1, πn =
µ1 µ2 · · · µn
Then,
Pn
1
−
g(λ + g)(2λ + g) · · · ((n − 1)λ + g) i=1 i+α
πn = e
(µ + h)(2µ + h) · · · (nµ + h)
Pn
1
ng g g g −
λ λ (1 + λ )(2 + λ ) · · · ((n − 1) + λ ) i+α
= e i=1
µn (1 + µh )(2 + µh ) · · · (n + µh )
µ ¶n Pn
1
−
Γ(1 + h/µ) λ Γ(n + g/λ) i+α
= e i=1 . (1)
Γ(g/λ) µ Γ(n + 1 + h/µ)

2
 nn √
Since Γ(n + 1) ≈ 2πn as n → ∞, then
en

µ ¶n ³ ´ Pn
1
Γ(1 + h/µ) λ n g/λ−h/µ−1 − i=1 i+α
πn ∼
= e .
Γ(g/λ) µ e

Let us assume
g h
≈ + 1. (2)
λ µ
Then (1) yields
µ ¶n − P 1
n
µ ¶n µ ¶−1
λ i+α λ n
πn = e i=1 ≈ 1+ . (3)
µ µ 1+α
Let the tail probability of the steady-state distribution be

P
N
πk
k=n
FN (n) =
S
P
N
where S = πk . The value FN (n) is equal to the probability that the long-time limit value of
k=0
the process falls in a state n ≤ i ≤ N .
Then
N µ ¶k Z+1µ ¶x
N
1 X λ 1 1 λ 1
FN (n) ≈ ≈ dx (4)
S µ 1 + k/α S µ 1 + x/α
k=n n

Let β = λ/µ − 1; Assuming β ≈ 0, then (1 + β)x ≈ 1 + βx. Therefore (4) becomes

1
FN (n) ≈ {α(1 − αβ)[ln(α + N + 1) − ln(α + n)] + αβ(N + 1 − n)} . (5)
S
Following the approximation (1 + β)x ≈ 1 + βx, we can also calculate S as
µ ¶
N
S ≈ α(1 − αβ) ln 1 + + αβN. (6)
α+1

Let us rank the market capitalizations in our investment universe, such that M1 corresponds to
the company with the largest capitalization. Therefore, the values Mi are ordered: M1 > M2 >
M3 > . . .. Then the empirical value of FN (i) becomes

i
FN (i) = P (M ≥ Mi ) = .
N
From (5), by substituting n = Mi and FN (Mi ) = i/N we obtain:
iS βMi
ln(α + Mi ) = C − − , (7)
N α(1 − αβ) 1 − αβ
β(N +1)
where C = ln(α + N + 1) + 1−αβ . Subtracting from (7) the resulting equation for the case
i = 1 yields to µ ¶
α + Mi 1−i β(M1 − Mi )
ln =S + (8)
α + M1 N α(1 − αβ) 1 − αβ
Since Mi , the size of a company, is in the range of millions (or any other appropriate scale), we
can safely assume that in reality α + Mi ≈ Mi for every i.

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 Therefore, from (8) our model is derived as follows:

i−1 β(M1 − Mi )
ln Mi = ln M1 − S + . (9)
N α(1 − αβ) 1 − αβ

If β = 0 in (9), we obtain a linear dependence between the logarithm of market capitalization

and the rank of a company in an investment universe. Parameters α and S need to be calibrated
by fitting the model to data sets via linear regressions (parameter S is a function of α and β a
shown in (6)).

3. NUMERICAL ILLUSTRATIONS OF THE SIZE DISTRIBUTION AND

ESTIMATION OF PARAMETERS

We are interested in applying our model to a broad universe of stocks, without making
restrictive assumptions, e.g., volatilities, growth vs. value, etc. Here, we considered all stocks in
Russell 2500 index, excluding the 10% of the companies with the smallest market capitalization,
e.g., typically, companies below $100 million in market capitalization. (The dependence for mini-
caps is different, and that requires further investigation). To illustrate the size distribution for
stocks, we plot the logarithm of their market capitalization versus their rank (Figure 1). We
calibrated the model at different periods and market conditions: December 1999 (before the US
market crashed in April of 2000), July 2002 (after the market corrected itself), and September
2004 (more recent observation). Figures correspond to end of month close stock prices.
In all graphs the linear trend is presented. In the usual scale this trend is depicted in an
exponential fashion. Therefore, visual evidence supports our model.

December 31, 1999 July 31, 2002 September 30, 2004

8 8
8 7.5 7.5
log market cap

log market cap

log market cap

7 7
7
6.5 6.5
6 6
6
5.5 5.5

5 5 5
4.5 4.5
0 1000 2000 0 1000 2000 0 1000 2000
rank rank rank

Figure 1. Size distribution of companies in the Russell 2500, excluding 10% of mini-caps,
i.e., universe of 2,250 companies.

The market cap vs. rank relationship, is approximated by means of a linear regression
equation, i.e., M̂ = b0 − b1 i. The regression results are presented in Table 1. In all cases, results
support the linearity claim, with high accuracy, e.g., R2 higher than 99% in all cases. The
standard error and, especially, the standard deviation sb1 for the slope b1 , are very small.

Table 1. Regression Statistics

ln M = b0 − b1 i R2 St. err. t Stat F sb1

12/31/99 ln M = 7.968 − 1.335 · 10−3 i 0.992 0.076 537 2.89 · 105 2.48 · 10−6
07/31/02 ln M = 7.634 − 1.274 · 10−3 i 0.991 0.079 491 2.41 · 105 2.59 · 10−6
09/30/04 ln M = 7.564 − 1.307 · 10−3 i 0.994 0.066 608 3.70 · 105 2.15 · 10−6

4
 Based on the above reliable regression results, we can now calibrate our model. For the
particular examples, we observe that ln Mi is linear function of i. Parameter α in (9) can be
calculated from the the estimated constant b0 and estimated slope b1 . In fact, from (9) and the
expression ln Mi = b0 − b1 i, we obtain
1 β(M1 − Mi )
b0 = ln M1 + S + , (10)
N α(1 − αβ) 1 − αβ
1
b1 = S . (11)
N α(1 − αβ)
Since b0 is a constant and Mi 6= M1 , i ≥ 2, then from (10) we obtain β = 0. From (11) and (6)
we obtain formula for coefficient α:
N
α= − 1. (12)
eN b 1
−1
For the particular data set, we have the following estimates of α: for 12/31/1999, α ≈ 116;
for 07/31/2002, α ≈ 135; for 09/30/2004, α ≈ 124; The presented numerical values of the co-
efficient α are close to each other and our assumption that α << M holds (M is measured in
millions).

To summarize, we showed here how the information of simple linear regression estimates can
model stock prices, via stochastic birth-death rates. In this particular example, looking at the
slope of the regression equation, a change in market capitalization is four to five times greater
than the change in the rank position. For example, a change in rank by 6 positions (among
2250), or 0.24%, leads, on average, to a 1% of market capitalization.

4. CONCLUSIONS

In this research a stochastic mathematical model for firm’s market capitalization is con-
structed. A linear dependence between the logarithm of market capitalization and the rank of
a company is demonstrated both theoretically and empirically. In a particular example in the
paper, we study the size distribution of 90% of the companies included in the Russell 2500 in-
dex. More specifically, our theoretical claim on linear dependence on the log-standard scale is
applied to 90% of Russell 2500 index (the smallest 10%, i.e., the mini-caps, are excluded). For
the mini-caps, a different model should be more appropriate, and we are currently investigate
this issue. Through simple linear regressions, we estimate the birth-death parameters of our
model, that can be used to forecast future market capitalization figures, and therefore, stock
prices. Also, our investigation demonstrates that the rank of a company is more robust than
its market capitalization. In the empirical side, we investigate the applicability of the model to
several domestic and international indices as well as particular sectors and industries.

REFERENCES
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