If you are like the majority of people who buy stocks you probably may have said or thought “wow, that stock is only $5, so cheap” or “I can’t believe Apple stock is $176 a share, so expensive.” After today, my goal is that you will no longer think of a stock as cheap or expensive based on its dollar value. As the title implies, a $1 stock can be more expensive to an investor than a $1000 stock.
Why Not Dollar Value?
To understand why you should not judge a stock by its dollar value, go back to exactly what a stock is. A stock is part ownership in a company; however, different companies have different amounts of stock in circulation, so we cannot even say that two $10 stocks would buy the same percentage of each company.
This can be exemplified in what is called a stock split. Companies can choose to effectively split their stock in order to make the stock appear “cheaper” (because they know that some retail investors see it that way.) All that happens when a company splits its stock, however, is that they change the number of shares in circulation. If you held 10 shares of a $10 stock, and the company did a 2 to 1 split, you would then be in possession of 20 shares of a $5 stock. You would also own the same percentage of the company as you did before, yet, people may feel that you own “cheaper stock.”
Furthermore, even if it were assumed that you could buy the same percentage of either company A or company B with a $10 investment, this does not mean that company A and company B are equally cheap.
Earnings
When you buy a business, you typically do so because you believe that the business will make money. This could be because it is an established business with a long term track record of profitability, or because you believe in the business’ future potential.
One of the most common is something called the price to earnings ratio or P/E Ratio for short. This metric effectively gauges how much are people willing to pay right now for a certain amount of earnings. If a company earns $5 per share, and the stock trades for $100 a share, its P/E ratio would be 20. So the question then becomes “is a P/E ratio of 20 cheap or expensive?” That, my friends, is where things get a bit murky. You can compare a company’s P/E ratio to other similar companyies to see if it is cheap or expensive relative to the competition. You can also compare it to the company’s historical P/E ratios to see if it is cheap or expensive relative to how it has traded in the past. Read more about P/E with this Investopedia article.
There are tons of ways to evaluate a stock price but the P/E ratio is a great place to start. Different versions of the ratio are based on either past earnings, future projected earnings, or even a combination of the two.
Other Options
While P/E ratios are a great place to start and a very common way to evaluate whether a stock is cheap or expensive, there are many other valuation models. If you are up for a deeper dive into stock valuation I recommend checking out this Investopedia article entitled “How To Chose The Best Stock Valuation Method.”
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