There is a common saying: “Don’t judge a book by its cover.” An equally valid truism for the investor could be: “Don’t judge a stock by its share price.” Many people incorrectly assume that a stock with a low dollar price is cheap, while another one with a heftier price is expensive.
In fact, a stock's price says little about that stock's value. Even more important, it says nothing at all about whether that stock is headed higher or lower.
Stock Price vs. Stock Value
The cheapest stocks—known as penny stocks—also tend to be the riskiest. A stock that has dropped from $40 to $4 may well end up at $0, while a stock that goes from $10 to $20 might double again to $40.
Looking at a stock’s share price is only useful when taking many other factors into account.
- A stock's price indicates its current value to buyers and sellers.
- The stock's intrinsic value may be higher or lower.
- The goal of the stock investor is to identify stocks that are currently undervalued by the market.
Some of these factors are common sense, at least superficially. A company has created a game-changing technology, product, or service. Another company is laying off staff and closing divisions to reduce costs. Which stock do you want to own?
You could be surprised. It pays to dig deeper. That game-changing company may or may not have a plan to build on its initial success. The markets have already priced in the value of that game-changing product. It had better have something good in the pipeline.
The company that is reducing costs may be streamlining its operations, and if it succeeds it could thrive again. Perhaps the herd has abandoned it too soon.
The goal is to identify stocks that are undervalued—that is, their prices do not reflect their true value.
What Price Tells You
Most people believe a stock's value is indicated by its price. That's only true to a certain extent. There is a big difference between the two. The stock's price only tells you a company's current value or its market value.
So, the price represents how much the stock trades at—or the price agreed upon by a buyer and a seller. If there are more buyers than sellers, the stock's price will climb. If there are more sellers than buyers, the price will drop.
An investor can investigate a company to determine its value. All of the information needed is online in the company's public financial statements. Online brokerages offer analyses and summaries of those results from many sources. Take a look at the facts.
When Price Matters
Companies raise cash by issuing equity or debt. The weighted average cost of capital (WACC) is a weighted average of a company’s cost of debt and cost of equity.
A stock is cheap or expensive only in relation to its potential for growth (or lack of it).
If a company’s share price plummets, its cost of equity rises, also causing its WACC to rise. A dramatic spike in the cost of capital can cause a business to shut its doors, especially capital-dependent businesses such as banks.
This problem should always be on the minds of investors following a sharp stock decline.
Don't Jump on Price
Investors often make the mistake of looking only at the stock price, because it is the most visible number in the financial press. In fact, it has meaning only in context.
For example, if Company A has a $100 billion market capitalization and has 10 billion shares, while Company B has a $1 billion market capitalization and 100 million shares, both companies will have a share price of $10. But Company A is worth 100 times more than Company B.
A stock with a $100 share price may seem very expensive to some retail investors. They might think that a $5 stock has a better chance of doubling than a $100 stock.
Market capitalization is a clearer indication of how the company is valued and gives a better idea of the stock’s value. Also known as market cap, it's listed with every stock's price quote.
Understanding Market Cap and Share Price
Stocks are divided into shares to provide clearly distinguishable units of a company. Investors then buy a portion of the company corresponding to a portion of the total shares.
The actual number of shares outstanding for publicly listed companies varies widely.
One way in which companies control the number of available shares and how investors feel about their share price is through stock splits and reverse stock splits. Stock prices can have a psychological impact, and companies will sometimes cater to investor psychology through stock splits.
For example, many investors prefer buying stocks in round lots of 100 shares. A share price of more than $50 may turn off the average investor because it requires a cash outlay of at least $5,000 to buy 100 shares. That's a large financial commitment to make to one stock.
As a result, a company that has had a good run and has seen its shares rise from $20 to $60 might choose to do a two-for-one stock split. Now the stock looks like a bargain to new investors. But its intrinsic value didn't change.
How Stock Splits Work
A two-for-one split means that the company will double the number of shares that each of its current shareholders owns by simply dividing the current price of its shares in half. Two new shares will be exactly equal to one old share.
A new investor might be more comfortable buying the shares at $30, making a $3,000 investment to purchase 100 shares. Note that the investor could have bought 50 shares before the split, and had the same percentage ownership in the company for the same $3,000 investment.
The current shareholder is pleased because that interest from new investors will drive the price of the shares higher.
This is why market capitalization is important. The company’s market cap will not change due to the split. If a $3,000 investment means a 0.001% ownership in the company before the split, it will mean the same afterward.
How Reverse Splits Work
A reverse split is just the opposite of a stock split, and it comes with its own psychology. Some investors view stocks that cost less than $10 as riskier than stocks with double-digit share prices.
If a company’s share price drops to $6, it might counter this perception by doing a one-for-two reverse stock split. In this case, the company will convert every two shares of stock outstanding into one share worth $12 (2 x $6).
The principles are the same. This can be done in any combination—three-for-one, one-for-five, etc. But the point is that this does not add any true value to the stock, and it does not make an investment in the company more or less risky.
All it does is change the share price.
If a company does a reverse split, beware. There was a good reason why that stock dropped to single digits.
Berkshire Hathaway vs. Microsoft
An example of a high price that may give investors pause is Warren Buffett’s Berkshire Hathaway (BRK.A). In 1980, a share of Berkshire Hathaway sold for $340. That triple-digit share price would have made many investors think twice.
As of April 1, 2020, Berkshire Class A shares are worth $261,250 each. The stock rose to those heights because the company, and Buffett, created shareholder value.
At that price per share, would you consider the stock expensive? The answer to that question, as always, does not depend on the dollar price of the shares.
The price of one share of Berkshire Hathaway Class A shares as of April 1, 2020.
Another example of a stock that has generated exceptional shareholder value is Microsoft (MSFT). The company’s shares have split at least nine times since its initial public offering (IPO) in March 1986.
Microsoft closed at $27.75 on its first day of trading. It was valued at $152.11 per share as of April 1, 2020. That seems like a decent return more than three decades later, but when all the splits are accounted for, a $27.75 investment in 1986 would be worth significantly more today. And, because the stock split, each share now also represents a much smaller piece of the company.
Microsoft and Berkshire both produced stellar returns for investors, but the former split several times, while the latter did not.
Does this make one more expensive than the other now? No. If either should be considered expensive or cheap, it should be based on the underlying fundamentals, not the share prices.
Factors Affecting Price and Value
The price and value of a stock may also be affected by fundamental factors. Each of the below is important.
A company's stock price is affected by its financial health. Stocks that perform well typically have very solid earnings and strong financial statements.
Investors use this financial data along with the company's stock price to see whether a company is financially healthy. The stock price will move based on whether investors are happy or worried about its financial future.
Company, Industry and Economy News
Any good news about a company will affect its stock price. It may be a positive earnings report, an announcement of a new product, or a plan to expand into a new area.
Similarly, related economic data, such as a monthly jobs report with a positive spin may also help increase company share prices. If the news is negative, though, it tends to have a downward effect on the share price.