How to Think About Stock Prices

It's a Mistake to Focus on Stock Price Alone Because Value Is What Counts

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.