What’s in a Stock Price?
I have been having an on going discussion with one of my friends about stock prices. Tom believes that the stock price itself determines whether or not a company is “expensive” or “cheap”. If you are going to invest in individual stocks, one of the first concepts to learn is that stock price by itself is largely irrelevant when determining the value of the company. The stock price must be paired with other valuation criteria to determine whether or not a stock is “cheap” or “expensive”.
Unfortunately, some financial writers some of whom should know better try to attract readers with misleading article titles, such as “Bargain $10 Stocks to Buy”, or “The Best Stocks under $20″. There is a small amount of relevance to stock prices in the sense that good quality large companies try to keep their stock price in the range of $30-$50 to appear “affordable” to retail investors. If the stock price of such a company did fall to under $20, this might imply that it was “cheap” because the price fell out of the normal price range.
Not all good quality companies split their stock to maintain a certain price point. There are some companies who have never split their stock. The most famous example of course is Berkshire Hathaway(BRK-A), led by Warren Buffet. Since its public offering over 40 years ago at a price of $15, the stock has never been split. At a price of $90,000 per share, very few retail investors can afford it so this is an extreme example of how a price can be a barrier (there are “cheaper” class B shares available at a cost of about $2,900). Other newer examples include the insurance company Markel (MKL) at about $300/share, and Google (GOOG) at $400/share.
If you only have $100 to invest, then a $400 stock is indeed expensive.
At the other end, very inexpensive stocks can be cheap due to company problems. The major stock exchanges require companies to maintain a minimum stock price ($1) or face de-listing. Also, stocks priced under $5 may be filtered out by large institutional investors who maintain minimum price levels.
For typical companies that are viable and stable, to determine if a stock is cheap, look at the companies earnings, free cash flow, balance sheet, and other criteria. As an example, compare Google to Bershire Hathaway, which is cheaper on an earnings basis? Even though Berkshire costs about $90,000 per share, that gets you over $7,300 of earnings in the past year. The earnings for a share of Google are only about $15. So, by that comparison Google is actually twice as expensive as Berkshire Hathaway.