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 had to choose between buying 100 shares of company ABC at $10 per share, or 10 shares of company XYZ at $100 per share, which one would you choose?
Many investors would go for 100 shares in ABC because the share price is lower. "The $10 stock looks cheap," they'd 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 may be 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 $100 stock is cheaper than the $10 stock.
Is It Worth It to Buy 10 Shares of a Stock?
Although there are reasons to buy round lots—meaning 100 shares of stock at a time—you don't need to shy away from buying smaller amounts if that's all you can afford. In fact, as more brokerages move to low- or even no-fee trades, it's less pressing (although still important) to take the expense of fees and commissions into account when you plan your trades.
You also buy fractions of a share through some brokers such as Charles Schwab. These are called fractional shares, and they're a way for investors of moderate means to buy into companies that may be out of their price range.
However, besides just considering the number of shares you must also evaluate whether the shares you are considering purchasing are appropriately priced.
How to Evaluate Share Price
Every share of stock in your portfolio represents a fraction of ownership in a business. To use an example, consider the Coca-Cola Company.
In 2019, Coca-Cola earned $8.9 billion in profit. The soft drink giant had approximately 4.3 billion shares outstanding.
That means that each of those shares represents ownership of 1/4,300,000,000 of the business (or 0.0000000002%) and entitles you to about $2.11 of the profits ($8.9 billion profit divided by 4.3 billion shares = $2.11 per share).
Assume that the company's stock trades at $50 per share and Coca-Cola's board of directors thinks that it is a bit too pricey for average investors. As a result, they announce a stock split. Stock splits make shares more affordable without diluting ownership for people who already own stock.
Companies can also do what's called a "reverse stock split," meaning if you hold 10 shares of a company that calls a 10-for-one reverse split, afterward you would hold one share.
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 8.6 billion from 4.3 billion).
The company would issue one share for each share an investor already owned, cutting the share price in half (for example, if you initially had 100 shares at $50 in your portfolio, after the split you would have 200 shares at $25 each).
Each of the shares is now only worth 1/8,300,000,000 of the company, or 00.0000000001%. Because each share now represents half of the ownership it did before the split, it is only entitled to half the profits, or $1.055.
The investor must ask himself which is better: paying $50 for $2.11 in earnings, or paying $25 for $1.055 in earnings? The answer is neither because, in the end, the investor comes out the same, since the split is always proportional.
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.
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 our first example, with companies ABC and XYZ, consider the following:
- Company ABC is trading at $10 per share and has earnings per share (EPS) of $0.15.
- Company XYZ is trading at $100 per share and has EPS of $35.
So which stock is the better value? Look at the earnings relative to price—otherwise known as the price to earnings ratio (p/e ratio).
The ABC stock is trading at a 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 ratio of 2.86 ($100 per share divided by $35 EPS = 2.86).
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 $2.86. 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. In January 2020, Berkshire Hathaway traded at more than $339,000 per share with EPS of $16,408 and a p/e ratio of 20.66. At the same time, the Coca-Cola Company was trading at $58 per share with EPS of $1.81 and p/e ratio of 32.49. Share price is entirely relative.