Why You Should Never Buy Stock on Share Price Alone
The Right Way to Determine If a Stock Is Over or Undervalued
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.
A Practical Example of How to Evaluate Share Price
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 number 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 $50s. 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.
An Example Illustrating Share Price Relative to Value
It all serves to make one very important point: the 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 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.