Recently Google made news for having its stock price hit $1000 per share. To which I heard many people say that Google is “too expensive” and that they prefer stocks that have a much lower share price. Here’s why that is a terrible investment philosophy.
In reality the share price has little to do with the value of an investment, and actually high share prices tend to point toward companies with more shareholder friendly policies (not always!). The most famous example of this is Warren Buffett’s Berkshire Hathaway stock, currently at about $176,000 per share. Does this mean his company’s stock is “more expensive” than others? Hardly.
The share price of a company’s stock is solely dependent on the number of shares the company has outstanding and its market cap (market cap is how much it would cost to buy all the shares of the company today).
Recall that a share of a company’s stock is literally a claim to a certain percent ownership of the company.
Consider an example:
Google (Ticker: GOOG) has a market cap of $335 Billion, a share price of just over $1000 a share and about 333 million shares outstanding.
Market Cap = # Shares Outstanding * Price per Share
That means that an investor who owns 1 share of Google stock owns about 1/333 millionth of the company.
Now consider Exxon Mobile (Ticker: XOM), which has a market cap of $387 Billion (Roughly 20% more than Google) But a share price of only $87 a share (About 90% less than Google). What’s the difference? Exxon has 4.4 Billion shares outstanding. This means that an investor who owns 1 share of Exxon Mobile stock only owns about 1/4.4 billionth of the company.
Each share of Exxon represents a much smaller portion of the company than a share of Google.
For an investor with $5000 to invest, they could either afford;
5 Shares of Google,
Or, about 57 shares of Exxon.
Either way, they have about $5000 invested.
If they own 5 shares of Google, and Google’s stock price goes up 10%, they make $500.
If they own the 57 shares of Exxon, and Exxon’s stock price goes up 10%, they make $500.
So, share price really means nothing.
What makes a stock “expensive”?
This is where fundamental analysis comes in. Reading a company’s financial statements and evaluating aspects of a company such as its profit, cash flow, margins, etc.
(Don’t know what these terms mean? Check out our Definitions pages, found here: http://begintoinvest.com/definitions/)
Consider a couple of examples:
Select between share price, P/E ratio and EPS (Earnings per Share – or the amount of profit each share is responsible for)
Example 1: Same Stock Price – Different Businesses
Netflix (Ticker: NFLX) and Blackrock (Ticker: BLK), a financial services company.
Netflix and Blackrock each have share prices around $320, but their businesses are entirely different.
Netflix has a market cap of about $19 Billion. Blackrock has a market cap of about $51 Billion.
Each share of Netflix is responsible for only about $0.80 in profit. Each share of Blackrock makes nearly $16 in profit.
Each share of Blackrock pays about $6.70 in dividends per year, each share of Netflix pays nothing.
So for $320, what would you rather have? The fact is, a $320 investment in Blackrock stock has a lot more value than a similar investment in Netflix. That $320 “buys” more profits and gets a 2% dividend.
Example 2: Cheaper Stock Price, But More “Expensive” Company
Facebook (Ticker: FB) has a share price of about $50 and Mastercard (Ticker: MA) has a stock price of $700.
Each share of Facebook is responsible for about $0.20 in profits, each share of Mastercard is responsible for about $25.00.
Facebook has a P/E of over 200, while Mastercard’s is under 30.
For an investor looking to buy $5000 in stock, they could choose either;
100 shares of Facebook,
Or 7 shares of Mastercard.
Each investment would cost the investor $5,000. But what does that investor get for that $5000?
$5000 worth of Facebook “Buys”:
- $20 in profit
- $100 in Free Cash Flow
- $0 in dividends
$5000 worth of Mastercard “Buys”:
- $150 in profit
- $131 in Free Cash Flow
- A small dividend
So what investment is really more “expensive”? An investor in Facebook is paying much, much more for the company’s profits and cash flow than an investor in Mastercard.
In Conclusion
What does a company’s stock price say about the company? Pretty much nothing.
Investors need to be worried much more about the fundamental aspects of the company. How much does the company make? How much am I paying for those profits? Can the company pay its bills? Etc. Our guides on financial statements have been some of the most popular posts on BeginToInvest.com. Check them out here:
Guide to the Cash Flow Statement
