In the world we live in, we are so used to associating the value of a product or service with its price. If something costs more, it usually means it is more valuable.
Unfortunately, this does not apply to shares.
Every now and then, you might hear comments about how a particular company is great because it has a higher share price than its competitors.
This is a myth.
Here’s the fact: A company’s share price alone tells you nothing about how valuable the company is. Price alone also tells you nothing about the size of a company.
I will not give you a detailed explanation about how a company’s share price is determined (you have Google for that!).
But to put it really simply, let’s assume you own a debt-free company and it is estimated to be worth RM100 by a collective group of experts whose sole purpose in life is to estimate the value of companies like yours (yeah, they do exist, and they’re usually known as stock analysts).
Let’s also assume that you’ve had enough of your company. Rather than shutting it down, you decide to give it away to 10 investors.
One way to do this is by issuing 10 shares, one to each investor. Theoretically, each share would be worth RM10 – simple math (RM100 divided by 10).
Now let’s assume, instead of 10 shares, you choose to issue 100 shares. In this case, each investor would receive 10 shares, each worth RM1 – again, simple math (RM100 divided by 100).
If you issue 1,000 shares, each investor would receive 100 shares, and each share would be worth RM0.10 – You get the point.
Notice how the price of a share has no bearing on the company’s value? Whether it’s RM0.10 per share or RM10 per share, the price reveals nothing about how much the company is actually worth – RM100 in this case. To estimate the company’s value, you also need to know the number of shares that have been issued.
Now let’s go one step further.
Let’s assume that this group of investors thinks your company is really worth RM200 instead of RM100 (Remember, the RM100 company valuation was originally assessed by the experts/stock analysts).
In this scenario, paying RM10 for a share – assuming you only issued 10 shares – is a huge bargain. Because to the investors, each share should really be worth RM20.
Of course, there can be many reasons why these investors think your company is worth more than it should (perhaps they know information about your company that the collective group of stock analysts missed, like how the company is close to developing a cure for cancer, or perhaps your group of investors believe with you gone, the company will finally reach its full potential).
The point is, RM200 is what the investors think your company is worth – It is a valuation that they have come up with independently, based on their best judgment. It is also an opinion. To the investors, at RM10, the price of your company share is really “cheap”, but as far as the group of stock anlaysts is concerned, RM10 is a fair price.
So what can we learn here?
1) The key takeaway is this: the share price of a company alone tells you nothing about the value of a company, because a company can easily manipulate its share price by issuing more or less shares.
2) Whether a company’s share is expensive or cheap depends on how much you think a company is really worth. So unless you are a seasoned analyst, or know something about the company that the public doesn’t, it’s probably more prudent to assume you don’t know.
3) I did not touch on this, but to determine the size of a company, the normal convention is to multiply the number of shares issued by the company with its share price (in finance, we call this the market capitalisation or “market cap” of a company).
In the above example, the market cap of your company is RM100 (10 shares issued x RM10 per share, or 100 shares issued x RM1 per share, or RM1,000 shares issued x RM0.10 per share).
Quiz: So what is the largest company in the world today?
Answer: Apple (at the time of writing), at market capitalisation of US$520 billion.
See some of Apple’s competitors below, and notice how the share price of each company really tells you nothing about its value or size.
Apple’s share price = US$560, market cap = US$520 billion
Google’s share price = US$570, market cap = US$186 billion
Microsoft’s share price = US$28, market cap = US$239 billion
And just for fun: which company has the highest share price in the world today?
Answer: Berkshire Hathaway (i.e. Warran Buffett’s baby), at the price of US$119,845 per share, market cap = US$198 billion
This guest post was written by Ching, the founder of iMoney.my, a price comparison website for Malaysians. Ching is a CFA charterholder, and was formerly an investment consultant and wealth advisor. Listen to my podcast interview with Ching here.