07 Sep Why Stock Prices Are Traps For The New Investor
Given a $1,000 investment capital, would you go with the option of purchasing 100 shares with company A (at $10 per share), or 5 shares with company B (at $125 per share)?
The majority of investors would choose the shares at company A due to the fact that the share prices are lower. Many of these investors would also think that the $125 shares of company B are too risky for their liking.
If you are one of those investors that agrees with this reasoning you may be in for a surprise.
Share price alone does not provide any information necessary for making an investing decision.
If you take the time to conduct the necessary research you may find out that the more ‘expensive’ stocks such as the $125 share of company B may be more affordable than the $10 share of company A for a few reasons.
Effect of Stock Splits on Stock Prices
Each share on your portfolio shows your fractional ownership in the relative companies. In the year 2001, Coca-Cola reported a profit of $3,696 billion. It had around 2.5 billion outstanding shares. This translate to 1/ 2,5000,000,000 ownership of Coca-Cola’s business for every share an investor owns. Dividing those numbers would give you $1.48 of profit per share.
Let’s say Coca-Cola’s stock traded at $50 per share in 2001 and the board of the directors decides that this amount is too expensive for the average investors and that it does not encourage more investors to purchase their stock. Hence, they decide to go for a “stock split”.
If the company decided in a 2-1 stock-split, this means that the outstanding shares would double from the original 2.5 billion to 5 billion. Coca Cola would give its investors 1 share for every share that they currently own while dividing their share price by half.
i.e. Assuming that you had 100 shares at $50 each before the split, you would end up with 200 shares at $25 each.
1 share would now only translate to 1 / 5,000,000,000 of ownership in the company, and would only give you $0.74 of the profits per share (compared to the original $1.48 profits per share)
For this reason the investor must now ask if it is a better choice to pay $50 to earn $1.48 off each share or to pay $25 to earn $0.74 off each share?
If you haven’t realised, its actually the same. This means that although many investors mistakenly believe that it is better to invest in a company after a stock split, it actually does not make a difference in the value of the stock. The only difference perhaps is the ability to start investing in the said company with a lower capital.
Share Price is Not Representative of a Stock’s Value
A share price on its own does not provide any substantial information about a company. Instead, share price should be used in relation to other factors such as earnings (Price to Earning) or net assets (Price to Book) when an investor is trying to evaluate a stock’s value.
Click here for a List of Terms that Investors Must Know.
It is also important to note that certain businesses decide never to split their shares. The stock prices of such companies may appear to way overvalued to new investors. (A famous example is Berkshire Hathaway, Warren Buffett’s conglomarate)
Do find out the reason for their expensive stock prices if you were to consider such companies. Do not take stock price at face value nor use it as the sole factor when making investing decisions.