How Much Is A Stock Really Worth?
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 stocks price is nothing more then 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 :-)