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Market Intelligence

What’s In A Share Price?

Seaver Wang | February 23, 2012

Not much at face value. Is Berkshire Hathaway (BRK.A) cheap or expensive at $112,860 per share? What about Sprint at $2.82 (S) per share. Novice investors often confuse low or high prices for cheap or expensive and there is a HUGE difference between the two.

Examples:

A) You have one pizza pie and slice it into 10 equal slices. Now, do you have 10 pizzas? No, you have 10 slices that equal the original one pizza.

Fine, but 20 people show up. So you double the number of slices to 20, equally. What is the change to the size of the pizza; its still just one pizza, just in smaller pieces. This is essentially the same as shares of stock.

B) Company A is worth $10 million and has 10 shares outstanding. Each share is therefore worth $1 million. The board of director wants more shareholders, so they have a 2-for-1 stock split and double the number of shares from 10 to 20. Each shareholder now owns two shares of the stock but worth half the price per share. There is no change in value.

Why are there stock splits and reverse stock splits then? There are some legitimate reasons, but none of them have a direct affect on the fundamentals of the company.

Stock Splits:

A company may split its stock (eg. 3-for-2, 2-for-1) because they would like to make it easier for more people to own shares. This can lower volatility in the trading of the stock. A lower price may make it more attractive to smaller investors who don’t have that much to invest. Berkshire Hathaway (BRK.A) has never had a stock split so over the decades the price continued to go up and is now over $112,000 for just one share. This high price discourages unnecessary trading and is less attractive to people who are not long-term investors. A company that splits its stock has likely done well recently and so if the momentum continues, the stock may continue to rise. Academic studies have shown that this can be a positive sign for a stock in the short term.

Reverse Splits:

A company’s stock that has declined dramatically (e.g. from $30 to $2 for example) might have a 1-for-10 reverse stock split, which would change the share price from $2 to $20 ($2 x 10). Again, this changes nothing about the value of the company itself. The effect is more psychological. Most institutional money managers have rules in place that prevent them from buying stocks below $10 per share. Stocks under $10 are often referred to negatively as penny stocks which are considered very risky and the antithesis of large dominating companies which are called Blue Chips. The $10 mark is purely arbitrary but can have a short-term affect on the stock because psychologically it is “safer” and therefore more attractive.

The value of a company’s stock is usually directly correlated to how much the company makes; that is, net profits after tax, divided by the number of shares outstanding. This is referred to as earnings per share or EPS for short. Even more important is how much an investor thinks the company will earn in the future. This is why many companies who are losing money often have rising stock prices, because investors/speculators assume that there will be profits in the future. More often than not, the forecasts are overly optimistic and a company that continues to lose money or makes less than expected will become more appropriately priced based on their current financial results.

 So to answer an earlier question, “What is the difference between low and high priced stocks?” I don’t think there is a definitive answer. It’s up to one’s personal tolerances. I’d say in general, anything under $20 per share can be considered low priced, and anything above $50 per share and up is high priced. But as I have pointed out above, is that even an important question? Not really, in my opinion.

“What is the difference between a cheap versus an expensive stock?” is more relevant. Here is an oversimplified example. See below.

Company A

 Stock price:$10 per share

 Annual Sales: $100 mill.

 5-year Expected Growth Rate: 10%

Earnings per share: $1.00

 P/E: 10.00

Company B

 Stock price:$100 per share

 Annual Sales: $100 mill.

 5-year Expected Growth Rate: 10%

Earnings per share: $15.00

 Risks are similar for company A and B

 P/E: 6.67

Source: Toinvest.tumblr.com

In this example, Company A and B are the same size with the same risk factors and same growth rates. Company A has a lower share price at $10, but comparing it to how much it earns, its P/E ratio (price divided by earnings) is higher than Company B. What this means is that you are paying 10x what the company makes in earnings for Company A but only 6.67x for company B’s earnings. Company B is clearly the better value because you get more earnings for each share you own. Why would there be this disparity in pricing. Well, it doesn’t happen often and is usually quickly corrected, so one would have to be alert to take advantage of these situations.

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