This is a question/concern I have received fairly often. Either the person I am talking to doesn't fully understand what the stock price means, or they don't understand the mechanics behind it.
So I wanted to write this post to help shed some light on the subject.
I want to start with this. The price of a stock is known as the price per share. So the price doesn’t actually matter. Here’s how the math works for the price.
Price Per Share = Company Value/Total Number Of Shares Outstanding
So in other words what actually matters is the value of the company you are buying.
If ABC Company had 100 shares outstanding and a valuation of $10,000 the price per share would be $10,000/100 = $100 and if you bought that share for $100 you would own 1%, or 1/100th, of the ABC Company.
But now let’s say ABC’s largest competitor, XYZ Company, has 50 shares outstanding and has the same valuation of $10,000 the price per share would be $10,000/50 = $200 and if you bought 1 share at $200 you would own 2%, or 1/50th, of XYZ Company.
The difference is the number of shares that makes two companies with the same valuations have different stock prices, and because one has less shares outstanding buying those shares give you a higher ownership percentage.
Apple has a current valuation of $2.285 trillion and has 15.82 billion shares outstanding.
$2,285/15.82 = $144.44
That means if you bought one share of Apple for $144.44 you would own 0.00000000632111252% of Apple.
1/15.82 billion = 0.0000000000632111252
But you can see that the price of a stock is simply a function of the company’s value and the number of shares they have outstanding.
Comparing companies with a similar values but different prices.
John Deere has a value of $124.94 billion and has 296.32 million shares outstanding.
$124,940 million/296.32 million = $421.64
Caterpillar has a value of $128.92 billion and has 516.35 million shares outstanding.
$128,920million/516.32million = $249.69
Neither company is really any cheaper or more expensive than the other but the price on each is drastically different.
This question really comes down to valuation. And the real question is how is that company valued.
A very common valuation tactic that professionals use is the price to earnings method.
Price/Earnings = Price Per Share/Earnings Per Share
Earnings Per Share = Company Earnings/Total Number Of Shares Outstanding
Let’s go back to ABC Company and XYZ Company.
If ABC Company earns $400 per year, still has a $10,000 valuation, 100 shares outstanding, and a price per share of $100. ABC Company’s earnings per share would be $4, then to find the price to earnings ratio you take $100/$4 = 25 times earnings. What that means is you would be paying $25 for every $1 dollar that ABC Company makes in earnings, and that’s a pretty good number in most cases.
On the flip side XYZ Company earns $600 per year, has a $10,000 valuation, 50 shares outstanding, and a price per share of $200. XYZ Company’s earnings per share would be $12, then to find the price to earnings ratio you take $200/$12 = 16.67 times earnings. That means you would pay $16.67 for every dollar that XYZ Company makes in earnings.
If the business model was 100% identical between ABC and XYZ you should choose XYZ, even though their price is double of ABC, because you would be paying less for XYZ’s earnings than ABC’s earnings. And to frame the return attribution in the long run, earnings make up about 80% of returns.
Let’s calculate the earnings per share of Apple and then find the price to earnings multiplier.
We know Apple’s price per share already is $144.44, Apple’s trailing 12 month earnings are $95.171 billion, and Apple has 15.82 billion shares outstanding.
$95.171 billion/15.82 billion = $6.02 Earnings Per Share
$144.44/$6.02 = 23.99x Earnings
Then to check out work to make sure our math makes it full circle.
23.99*$95.171 billion = $2.283 trillion
$2.283 trillion is the value of Apple.
What the 23.99 times earnings means is that you would pay $23.99 for every $1 of Apple’s earnings.
Comparing companies with different prices and different price to earnings.
For this we will reference the Apple example above and then compare it to Microsoft.
Microsoft has a price per share of $247.21, 12 month trailing earnings of $67.449 billion, value of $1.829.96 billion, and 7.44 billion shares outstanding.
$67.449billion/7.44billion = $9.07 Earnings Per Share
$247.21/$9.07 = 27.26x Earnings
In this case you would pay $3.27 more for every dollar of Microsoft’s earnings than you would Apple’s.
Why would we pay more for Microsoft earnings than we would Apple earnings? Or why does the market pay more for Microsoft earnings than they would Apple earnings?
And the answer is hard because it’s subjective. Do investors think Microsoft earnings are stickier (meaning earnings won’t decline), or that Microsoft’s earnings growth from here will be higher (effectively dropping the amount you pay for each dollar of earnings), or because Microsoft has higher profit margins.
These are the questions investors need to be asking themselves when deciding on whether to purchase a stock or not. The per share variables, which include price and earnings per share, are fairly irrelevant.
In conclusion, what you really need to know is how the business operates, how it returns cash to shareholders (dividends, buybacks, debt paydown), and how it generates cash flow.
Hopefully this helps paint a clear picture of what you really need to watch.
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