How to Think About Stock Prices

How to Think About Stock Prices explained by professional Forex trading experts the “ForexSQ” FX trading team.

How to Think About Stock Prices

Time for an investing pop-quiz. If you had $1,000 to invest and were given a choice between buying 100 shares of company ABC at $10 per share, or 5 shares of company XYZ at $125, which one would you choose? Many investors would go for the one hundred shares of ABC because the share price is lower. “The $10 stock looks cheap,” they argue, “the $125 per share price for the other stock is too risky and rich for my taste.”

If you agree with this reasoning, you’re in for a shock. The truth is, you don’t have enough information to determine which stock should be purchased based on share price alone. You may find, after careful analysis, the $125 stock is cheaper than the $10 stock! How? Let’s take a closer look.

Share Price and Stock Splits – The Coca-Cola Example

Every share of stock in your portfolio represents a fractional ownership in a business. In 2001, Coca-Cola earned $3.696 billion in profit. The soft drink giant had approximately 2.5 billion shares outstanding. It means that each of those shares represents ownership of 1/2,500,000,000 of the business (or 0.0000000004%) and entitles you to $1.48 of the profits ($3.696 profit divided by 2.5 billion shares = $1.48 per share).

Assume that the company’s stock trades at $50 per share and Coca-Cola’s board of directors thinks that is a bit too pricey for average investors.

As a result, they announce a stock split. If Coke announced a 2-1 stock split, the company would double the amount of shares outstanding (in this case the number of shares would increase to 5 billion from 2.5 billion). The company would issue one share for each share an investor already owned, cutting the share price in half (e.g., if you had 100 shares at $50 in your portfolio on Monday, after the split, you would have 200 shares at $25 each).

Each of the shares is now only worth 1/5,000,000,000 of the company, or 0.0000000002%. Due to the fact that each share now represents half of the ownership it did before the split, it is only entitled to half the profits, or $0.74.

The investor must ask himself which is better – paying $50 for $1.48 in earnings, or paying $25 for $0.74 in earnings? Neither! In the end, the investor comes out exactly the same. The transaction is akin to a man with a $100 bill asking for two $50’s. Although it now looks like he has more money, his economic reality hasn’t changed. It, incidentally, should prove it is pointless to wait for a stock split before buying shares of a company.

Share Price Relative to Value

It all serves to make one very important point: share price by itself means nothing. It is share price in relation to earnings and net assets that determine if a stock is over or undervalued.

Going back to the question I posed at the beginning of this article, assume the following:

Company ABC is trading at $10 per share and has EPS of $0.15.
Company XYZ is trading at $125 per share and has EPS of $35.

The ABC stock is trading at a price to earnings ratio (p/e ratio) of 67 ($10 per share divided by $0.15 EPS = 66.67).

The XYZ stock, on the other hand, is trading at a p/e of 3.57 ($125 per share divided by $35 EPS = 3.57 p/e).

In other words, you are paying $66.67 for every $1 in earnings from company ABC, while company XYZ is offering you the same $1 in earnings for only $3.57. All else being equal, the higher multiple is unjustified unless company ABC is expanding rapidly.

Some companies have a policy of never splitting their shares, giving the share price the appearance of gross overvaluation to less-informed investors. The Washington Post, for example, has recently traded between $500 and $700 per share with EPS of over $22. Berkshire Hathaway has traded as high as $70,000 per share with EPS of over $2,000. Hence, Berkshire Hathaway, if it fell to $45,000 per share, may be a far better buy than Wal-Mart at $70 per share.

Share price is entirely relative.