Don't Let Stock Prices Fool You

A common saying says, "Don't judge a book by its cover." Some equally valid words of wisdom for investors could be, "Don't judge a stock by its share price." Despite much readily available information for investors, many people still incorrectly assume that a stock with a small dollar price is cheap, while another with a heftier price is expensive. This misconceived notion can lead investors down the wrong path and into some bad decisions for their money.

The cheapest stocks - "penny stocks" - also tend to be the riskiest. That stock that just went from $4 to $0.40 might end up at zero. And a stock that goes from $1 to $2 might double again to $4. Looking at a stock's share price is only useful when taking many other factors into account.

Many Factors to Consider

Investors often make the mistake of looking only at stock price, because it is often the most visibly quoted number in the financial press. However, the actual dollar price of a stock means very little unless many other factors are considered. For example, if Company A has a $100 billion market capitalization and has 10 billion shares, while Company B has a $1 billion market capitalization and 100 million shares, both companies will have a share price of $10, but Company A is worth 100 times more than Company B.

A stock with a $100 share price may be intimidating to many retail investors, because it seems very expensive. Some investors think that a triple-digit share price is bad, and they feel that a $5 stock has a better chance of doubling than the $100 stock. This is a misguided view, because the $5 stock might be considerably overvalued, and the $100 stock undervalued. The opposite also could be true as well, but share price alone is no sign of value. Market capitalization is a clearer indication of how the company is valued, and gives a better idea of the stock's value.


Real World Example


An example of where a high price may have made investors pause is Warren Buffett's Berkshire Hathaway (NYSE:BRK.A). In 1980, a share of Berkshire Hathaway sold for $340. The triple-digit share price would have made many investors think twice. However, Berkshire Class A shares are worth $173,300 each in 2013. The stock rose to those heights because the company, and Buffett, created shareholder value. At $173,300 per share, would you consider the stock expensive? The answer to that question does not depend on the dollar price of the shares.

Another example of a stock that has generated exceptional shareholder value is Microsoft (Nasdaq:MSFT). Microsoft's shares have split multiple times since its IPO in March 1986. Microsoft closed at $27.75 on its first day of trading, and is currently valued at $32.93 per share in 2013. That seems like a meager return over 20 years, but when all the splits are accounted for, a $27.75 investment in 1986 would be worth significantly more today. Because the stock did split, the share price in 2013 was $33, but each share also represented a much smaller piece of the company.

Microsoft and Berkshire both produced stellar returns for investors, but one decided to split several times, while the other did not. Does this make one more expensive than the other now? No - if either should be considered expensive or cheap, it should be based on the underlying fundamentals, not the share prices.

Conclusion

Some investors may focus on share price when looking at a stock, because it is the most visible number in the financial press. Investors should not get fixated on share price alone, because companies can change share prices dramatically through stock splits, reverse splits and stock dividends without changing fundamentals. Dig a little deeper when thinking about your next investment, and remember that a stock with a high price can go much higher under the right circumstances, just as a stock with a low price can sink even further if it isn't really a good value.

*Note: Article have been extracted and edited from: Don't Let Stock Prices Fool You | Investopedia http://www.investopedia.com/articles/stocks/08/stock-prices-fool.asp#ixzz4C87INg7S