Why Per-Share Price Is Not as Important as Market Cap
Market cap is the true measure of a company's value
There's a common misconception that a company's per-share stock price holds as much importance as its total market capitalization when it comes to choosing stocks to purchase. This fallacy occurs especially often in the case of new investors. A company's market capitalization should be your key consideration when you're evaluating a stock because it tells you the value of a company.
The Per-Share Price Fallacy
Why would a stock that costs $50 per share be worth less than another stock priced at $10 per share? This question highlights a point that often trips up beginning investors.
Beginning investors feel the per-share price of a stock conveys some sense of value relative to other stocks. But, nothing could be farther from the truth.
In fact, the per-share price of any given stock has virtually no meaning to investors doing fundamental analysis except for its use in some isolated calculations. If you follow the technical analysis route to stock selection, it’s a different story, but stay with the fundamental analysis for now.
Don't be concerned with the per-share price because it's always changing, and each company has a different number of outstanding shares. This being the case, it doesn’t give a clue as to the value of the company. For that figure, you need the market capitalization or market cap number.
Determining the Market Cap
You can easily find a company's market cap by multiplying its per-share price by its total number of outstanding shares. This number gives you the total value of the company or stated another way, what it would cost to buy the whole company on the open market.
Coming up with a company's market cap and comparing it to other companies involves some simple math as follows:
- Stock price: $50
- Outstanding shares: 50 million
- Market cap: $50 x 50,000,000 = $2.5 billion
Look at this second example:
- Stock price: $10
- Outstanding shares: 300 million
- Market cap: $10 x 300,000,000 = $3 billion
Look at these two companies in this manner for evaluation purposes, since their per-share prices tell you nothing by themselves.
What You Can Learn From Market Cap
So what does market cap tell you? First, it gives you a starting point for evaluation. When you're looking at a stock, it should always be in a particular context. For example, how does the company compare to others of a similar size in the same industry? The market generally classifies stocks into three categories:
- Small Cap: under $1 billion
- Mid Cap: $1 billion to $10 billion
- Large Cap: $10 billion plus
Some analysts use different numbers and others add micro caps and mega caps. You can talk to financial experts about their particular preferences, but the most important point is that you understand the value of comparing companies of similar size during your evaluation. You'll also use the market cap in screens when looking for a certain size company to balance your portfolio.
The Bottom Line
Don’t get hung up on the per-share price of a stock when you're making your evaluation. It really doesn’t tell you anything. Focus instead on the company's market cap to get a picture of the company’s value in the marketplace.
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