A stock price is nothing but a number. It tells you nothing on its own. So why then does the media concentrate on stock prices so much? It is because they want to sell you something and keep your eyes glued to the screen. But a stock price is nothing but a number.
This lesson aims to dispel the many myths surrounding stock prices. This might seem like a very basic post to someone who has been in the investing game for a while but it is amazing how many questions I get on this topic each week. So I am putting it all in one quick post for easy reference.
One of the biggest misconceptions faced by new investors is the assumption that a higher stock price means that a share is expensive and a lower stock price means that a share is cheap.
For example, if company A is trading at £100 a share and company B is trading at £50, a lot of people will think that shares in company A are expensive whilst those of B are cheap.
This is completely wrong. Just because you need to fork out more for shares in company A doesn’t mean it’s expensive.
Instead, you need to look at the value you are getting for your purchase.
Let’s look at an example in terms of rental property which everyone seems to understand.
Say they are two houses, House A is selling for £100,000 and House B selling for £50,000. Which one is cheaper? At face value, it looks like B is.
But House A receives an annual rent of £80,000 whilst B only receives £10,0000.
Which one is better valued now? Once I have given you the full information surrounding the properties, House A is now more attractively valued and is cheaper so to speak.
Likewise with shares. Don’t just look at the face value which is the stock price.
A larger number or a smaller number means nothing.
Instead, collect all the information. Look at the revenues, profits, cash flows, shares outstanding and the balance sheet instead of just looking at the share price.
Let’s take a look at another example in order to cement our understanding.
Say there are two companies, Company X and Company Y.
Company X shares trade at £20 a share whilst company Y trades at £10 a share.
They both are the same in every sense with both earning profits of £1,000.
The only difference is Company X has 100 shares outstanding whilst Company Y has 500 shares outstanding. Which is cheaper.
Again in this example, the shares with higher nominal values are cheaper.
This is because Company’s X profit are only split 100 ways so each share has £10 worth of profit or is valued at a P/E of 2 (20/10=2).
On the other hand, Company Y has split 500 ways so each share only has £2 worth of profits.
It is valued at a P/E of 5 (10/2=5). So it is the more expensive stock.
So don’t just look at the stock price in determining whether a particular share is cheap or expensive.
A larger number or a smaller number means nothing.
Get all the facts and then make your decision.
Another common misconception is faced by those investors who just look at stock charts.
They think just because a stock is going up it is doing good or just because it is going down it is doing badly.
But again this is incorrect.
Stock prices move for any number of reasons.
It doesn’t necessarily move in accordance to how the underlying business is doing.
Just because a company is becoming more profitable doesn’t necessarily mean its stock price will go up.
And just because a business makes huge losses year after year doesn’t mean its stock price will go down.
Psychology and stories play a big role.
Examples of companies that are super profitable but have falling share prices can be found in the tobacco sector.
Due to the ESG (Environmental, Social and Governance) investing movement, a lot of the big investors such as pension funds and insurance companies are no more allowed to hold shares in these cigarette makers. So they have been selling shares in these companies forcing the price downwards.
Thus share prices in tobacco companies have been falling even though the business performance is steady.
On the other extreme, you get story stocks where people buy into the story more than the business itself.
Tilray, the Canadian canabis company, is a good example of this. The company’s shares went from its IPO price of $17 to a high of close to $150 in the span of three months.
Looking at the share price alone you would have thought Tilray was doing great. But the company makes huge losses quarter after quarter and rightly so its share price has fallen to below the IPO price.
So be careful not to be caught up in a story stock.
Also, it is also worth mentioning that stock price charts do not give you the total return figures earned by shareholders.
They do not take into account dividends for instance. Go look at the stock chart for BP or GSK and you will think they have gone nowhere for 20 years.
That is because the stock price does not factor in the torrents of cash dividends paid to investors by these companies.
You cannot look at the stock price alone.
It doesn’t tell you what you need to know in most cases unless
1.) a company refuses to split its stock
2.) the company doesn’t pay cash dividends
and 3.) the company doesn’t spin-off any holdings.
Very few businesses pass all three tests.
The only example which I can think of is Berkshire Hathaway, which rose from $8 a share back in the 1960s to $280,000 per share today.
I hope this lesson has taught you not to pay too much importance to the stock price. Instead, study the underlying business and ensure it is doing well.
In the next lesson, we will look at what determines the rate of return on a stock. So be sure to keep an eye out for the stock market guide page.