Why Stock Price Does NOT Matter
Oh yes, you read that correctly! Many people erroneously believe that if one company has a higher share price than another, it must be worth more or, in other terms, have a higher equity value (the value of a company that shareholders create by investing in that company). But, interestingly enough, that is not always the case. Let me try to show you why…
For example, assume Company A has a stock price of $100 per share, and Company B’s stock price is $10 per share. Company A might seem more valuable in the eyes of many, yet there is a factor we are forgetting!
In order to determine the true value of a company, we also need to know how many shares each company has outstanding (meaning the number of shares that are currently owned by stockholders including stock owned by company officials). If Company A has 10 shares, then one can properly value the company’s equity value at $1,000 ($100/share x 10 shares outstanding). Now, lets say Company B has 150 outstanding shares which would result in Company B having an equity value of $1,500 ($10/share x 150 shares outstanding). Company B has a higher equity value despite having a lower stock price. While Company A may feel more expensive, especially since you have to spend more to purchase a single share of stock, Company B holds more value.
A real world example: Apple’s stock price is around $205 today (4/22/19) and Amazon’s price per share is $1,885. Amazon’s stock price is about nine times more than Apple’s, but this does not mean that Amazon is nine times more valuable. When you look at their equity values, both Apple and Amazon have an equity value around 960 billion dollars.
How does one decide the price of a single share?
That is where living in a capitalist market comes into play. Because of the free market, people decide how much a share is worth. Something is only worth how much a buyer is willing to pay for it. There needs to be an agreement between a buyer and seller. If a buyer thinks the share is only worth $5, yet there are no sellers willing to sell the share for $5, the reality is the share is worth more than $5. The opposite is also true. If a seller believes that his single share is worth $20, but people are only willing to purchase it at $5, then it is only worth $5. Therefore, the share price is being determined on a continuous basis by “the market” – buyers and sellers agreeing on a price on which they want to transact.
Finally, how do people decide how much they are willing to pay for particular companies stock?
In the simplest terms, value is determined based on the amount of a company’s profits and revenue and the prospects of those profits to grow or decline in the future. In fact, this is why many people use what is called a P/E ratio to determine if a company is “expensive” or “cheap”. The P/E multiple equals the PRICE for a share of stock divided by the EARNING for a share of stock. It is easy to see the price per share; however, the earnings per share is more difficult to determine. In order to determine the earnings per share, we need to know–yes, you guessed it–the number of shares outstanding. If a company has high P/E ratio, it can be considered to be more expensive than a lower P/E ratio, as it implies that people are willing to spend more money for $1 of earnings for each share. People may be willing to pay more for a $1 of earnings if they think those earnings will grow.
I hope I was able to clarify that stock price does not matter in comparing values of different companies.