-Jan-
06
How Much Is A Stock Really Worth? (Technorati) Technorati | (Del.icio.us) Del.icio.us | (Digg) Digg | (Blinklist) Blinklist | (Comment) Comments (8)

I talk virtually every day to many different novice investors and one of the biggest misconceptions that I hear day in and day out is that a stock is priced too high to buy. These investors seem to be more concerned with how many shares they can pick up, rather then focusing their attention on what really matters - a stocks price-to-earnings (P/E) ratio. People often forget that a stocks price is not "real"; a stock's price is simply a ratio created by the companies through stock splits and share adjustments. Don't let the stock price fool you!

As a consumer we look at real prices every single day of objects we intend to buy. This basic economics they teach. We compare these prices against similar objects and thus make the best purchasing decision based on our research. We can easily decipher between products that are over valued and those that are bargains. Take car shopping for example. Imagine you had to choose between two identically priced cars at $20,000 dollars a piece. Both come from the same class (sector), that being the midsize car family. One car is an 2006 Acura TL ($35,000+) and the other is a 2006 Honda Accord ($20,000). Both are priced at $20,000 dollars but you can clearly see what one is the better deal.

Now lets take two stocks - we will look at Google (GOOG) and Yahoo (YHOO) again. Both Internet stocks in competing sectors. Google is price today at $465/share and Yahoo at $43/share. Are these two stocks the same price? The beginner of course would say "no", Google is way more expensive then Yahoo! However, you need to better understand the underlying worth of these Internet giants as compared to their arbitrary price per share to really answer this question. We can make this comparison by viewing the price-to-earnings ratio of the two companies.

To find out the P/E ratio for any company, all one needs to do is divide the current price of the stock to the companies earnings per share.

YHOO P/E = Stock Price/2005 Earnings = $43/$1.07 = 40 multiple (rounded)
GOOG P/E = Stock Price/2005 Earnings = $465/$4.51 = 103 multiple (rounded)

This is where it gets really interesting. GOOG with a price of $465/share would seem almost 10 times more expensive then its Internet counterpart YHOO at $43/share. However, a closer look at the price-to-earnings ratio shows that Google is actually only trading at about 2x the multiple of YHOO or 63 multiple points. This is about a 150% difference in multiples and not a 1000% difference as reflected in the share price. This is still a considerable difference and much of the Google run-up this year is in anticipation of the increase in earnings per share you will see. This type of growth is what Wall Street eats up.

To recap: remember that a stock's price is nothing more than the Multiple multiplied by the Earnings (M x E = P). Don't let a stock with a high price scare you and don't make any rash investment decisions until you have researched a stocks true value as compared to its competition - or you may miss some really good investment opportunities, like when Google traded at $200/share and people thought that was too much. Happy Investing :-)

8 Comments - Post your comment below.


Katie
Jan. 7, 2006

That is something that I never really understood before, so thanks for your explanation. I imagine that most casual traders also do not fully understand this situation, and so a lot of mistakes happen in the process. I wonder--does this common misunderstanding give some stocks an advantage in the market? (Such as Yahoo that seems like a better deal on first glance). I wonder how different companies could use this misunderstanding to promote stocks that don't bring in as much money per share but may seem to to the untrained eye.


Chad Lapa
Jan. 7, 2006

That is an interesting thought Kate. The truth is that it doesn't give certain stocks an advantage per say. What it does do though is create a lot of missed opportunities for amateur investors. People who see a stock price as being "too high" to own so they won't own as many shares, thus allowing them to rationalize not buying a stock. If for example, you could own 100 shares of a $10 dollar stock or 10 shares of a $100 stock - the difference in total price is none of course. Where amateurs make their mistake is in thinking that if they buy the $10 dollar stock, it only has to move $1 dollar and they will make 10% on their money, but if they buy the $100 stock, then the price will have to move $10 dollars in order to make 10%. To them it looks easier to to go from 10 to 11 then 100 to 110. This is not what you should be paying attention too when you buy a stock. You need to look at a companies fundamentals, earnings, current market conditions and what sector they are in and base your investment decision of this type of research rather than eliminating a potential stock from your portfolio simply because the price is too high. When Google went public – it quickly went from 100 dollars per share to near 500 today. This is essentially the same as seeing a stock go from 10 to 50, but if that 100 dollar per share was “too much”, then you would have missed this great opportunity. Does this make sense?


John
Jun. 27, 2006

hi my name is john and I was if anyone could give me any advice on gettting into the stock market and how I would go about doing this.Other than the usual advice such as get a broker and play it smart.I would appreciate any help.thanx


Chad Lapa
Jun. 27, 2006

John,
In order to "get into the stock market" you will need a broker of course. I won't lecture on this as it seems you are familar with how the process works already. To really get into the market more, I would suggest following CNBC and keeping up with the worldly business news. On top of this, my personal favorite investing "program" out there is called Investools. This will really better help you understand some very important aspects of the markets such as fundamentals, sectors and institutional money flow. I hope this helps :-)


Gravis Allenson
Oct. 24, 2006

So please correct me if I'm wrong- Is the multiple and price to earnings ratio the same thing?

If this is the case, could you recommend a site that allows you to comprehensively compare these two?

Thanks
Gravis


Chad Lapa
Oct. 24, 2006

Sorry if that confused you Gravis. To answer your question, YES the price to earnings ration (P/E ratio) is the same thing as the multiple. Almost every big financial site out there will give you the P/E ratio. I personally use Yahoo Finance. Take care.


Ava I SAAC
Nov. 26, 2007

I have 5 shares in bidbay.com and i would like to know if it is worth anything and how much


Tina
Mar. 11, 2010

So how do you find out what an old stock is worth, if there is any? I have 10 shares of 1938 American Legion Post 1 stock.

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