One statement I often see in my inbox is ‘ I will not buy company X stock because it has a high price and is too expensive. I would rather buy Company Y as the share price is lower.’
This is a common misconception many first time investors have. Just because the price of a stock is high does not mean it is expensive. And just because a company has a low stock price does not mean it is cheap. You need to look at more than just the ticker price to identify an expensive or cheap stock.
Have a look at the following example.
Company A and Company B both make £2 million in after tax profit a year. The companies are identical in every sense of the word. The only difference is that Company A has split itself into 500,000 shares i.e. it has a shares outstanding figure of 500,000. On the other hand, Company B has 100,000 shares outstanding.
If Company A’s shares are trading at £20 and Company B’s shares trading at £40, which one is cheaper by value?
The answer is Company B.
This is because Company A is trading at a P/E ratio of 5 (£2 million / 500,000 = £4 *5 = £20). Thus you are paying £5 for every £1 worth of profits.
On the other hand, Company B is trading on a P/E ratio of 2 (£2 million / 100,000 = £20 *2 = £40). Thus, you are only paying £2 for every £1 worth of profits.
This should thus prove that just because one company’s share price is higher than another, it does not mean it is more expensive. You need to look at things such as the shares outstanding to see how many pieces the company’s profits are sliced into.