What does the stock price mean?

When you look at the stock prices of various businesses, you will see that they vary greatly.  In general they range from around $5.00 to $100 per share.  But there are stocks with share prices greater and less.  For example, the stock of Berkshire Hathaway (Warren Buffet’s company), sells for over $100,000 per share.  But generally, share prices are kept under $100.00 each.  The theory is that in general practice, individual investors would buy company shares in a lot of 100 shares.  By keeping the share price under $100, the investor would need a maximum of $10,000 to purchase 100 shares.  How is the share price kept under $100?  Through a stock split that we will address later.  There is no absolute “rule” governing the price of a share and you should not assume that the relative stock price says anything about the value of the business.

For example, if the shares of company A are selling for $20 and the shares of company B are selling for $40, which is better to own?  From this information alone, you have no way of knowing.  Just because company B is selling for more than company A doesn’t mean that it’s a better company to own.  You have to know much more about the company, for example the quality of its balance sheet, its earnings (EPS), its prospects for revenue and earnings growth in the future, cash flow, its products and services, quality of the management, etc.

The most commonly used metric to help evaluate the share price is the PE ratio, or price/earnings ratio.  This is derived by dividing the share price by the yearly EPS.  For example, if the share price is $20 and the recent earnings are $2.00 per share, then the PE ratio is $20.00/$2.00 = 10.  This provides a means to compare the share price to the share price of other companies.

Think of this as an analogy to shopping for paper towels.  The store will generally have single rolls and packages of multiple rolls.  You’d like to know which represents the best value.  Generally, you’ll do this by comparing the cost per roll.  This simplifies the comparison.  For stocks, EPS and the PE ratio give you a means to compare the relative value represented by the share price for a particular stock.

A low PE ratio represents a business selling at a relatively low value compared to its earnings and MAY indicate a good value while a high PE indicates that this company is expected to experience rapid earnings growth but MAY represent an over priced business.  However, there are many other factors to consider.  The primary one is the rate at which the company can/may grow its earnings.  For example, the stock of an electric utility company, for example, Consolidated Edison (ED) will most likely sell at a low PE because it’s not expected to grow its earnings very rapidly.  Its rates are regulated so its growth will be relatively slow but predictable.  However, the stock of Chipotle Mexican Grill (CMG) trades at a relatively high PE because it is growing rapidly by adding many new restaurants each year.

You can find this kind of information for any traded stock using many different web sites.  A good one is Yahoo finance.  There you can enter the stock symbol or company name and get a quote that will show the current stock price and much more, including the PE ratio, market cap, etc.


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