Share Price Alone is Meaningless

This week has been extremely hectic because of various phone consults. Nonetheless, I woke up this morning and I felt this urge to do a blog post for everyone! Enjoy!

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The Correct Questions Lead to Correct Behavior

This would likely to be a typical conversation between investors. Let’s call them Alex and Germaine.

Alex: “Hey Germaine, I found a company and it looks good!”

Germaine: “Woah, Alex, really? What is the share price now?”

Alex: “Hmm, the last traded share price was US $102!”

Germaine: “Hmm, the share price is so expensive, the company must be overvalued. We cannot buy this company, I won’t buy money buying companies with high share prices.”

Have you had such conversations before? Or do the sentences reflect your current mentality on share prices?

“I will never buy any companies with a share price above $10”

“I will buy a company only if it is at its all-time low”

You see, looking at share prices alone is often meaningless. 

Share prices have to be compared with something. In this case, it must be compared with the earnings or cash flow (value) of a company.

It applies to not just investing in stocks, but all things in life.

You cannot say a particular car is expensive without knowing the model of the car.

You cannot say a particular property is expensive without knowing the location of the property.

So, when we make the simple conclusion that a company is expensive on the basis of looking at the share price alone, we are giving up a lot of opportunities.

Google rose from US $200 to >$1,000. Amazon rose from US $200 to >$1,000 as well.

Wasn’t $200 considered expensive already? Are they really expensive or can they still be considered as cheap?

The Concept of Price Multiple

How do we derive what is a suitable price to pay for a business?

You cannot simply pluck a figure out of air.

Whether it is a listed company or private company, a price is determined based on the earnings or cash flow produced by the business. It’s what we call as price multiple.

If a company called GreenPalms earned $1 million, and I paid $10 million, the price multiple is 10x ($10m/$1m).

I’m paying 10x for every dollar earnings produced by the business.

A private company usually has less than 10 shares. Assuming it has 10 shares, the ownership of one share represents 10% ownership in the company. 

For a publicly listed company, there are usually a high amount of shares outstanding.

Assume that a company has 1,000,000 shares, owning a few shares represents a tiny fraction of ownership in the company. 

Coming back to GreenPalms, how do I know what is the earnings per share? I will take the earnings divided by the number of shares outstanding. 

If GreenPalms has 1,000,000 shares in the company, the earnings per share would be $1 million divided by 1,000,000 shares. The answer is $1 earnings per share.

Likewise, if GreenPalms has a share price of $20? How do we know the total price of the company? We will take $20 (per share) multiply by 1,000,000 and we will get an amount of $20 million..

It is what we know as today, the Price-to-Earnings (PE) Ratio. If you pay a higher price multiple, it means the PE ratio goes up. You are paying more for per dollar of earnings.

Price multiple, in short, is also known as the valuation of a company.

Occasionally, you would see very strong companies like Facebook trading at high price multiple of 21x. A higher price multiple is usually given to companies which are in their high growth stage, dominant, and very stable.

Look at Price Multiple, Not Share Price!

Now we know that it is practically useless to look at company share prices without the context of its earnings, let me demonstrate using a few examples!

Data is extracted from Koyfin.com. As of 17 August 2019.

Most of you would be familiar with the companies except for Alphabet.

Alphabet is the holding company of Google.

An investor could be paying $1,167.3 for one share of Alphabet and ended up paying a price multiple of 23.6x.

Similarly, an investor could be paying $155.8 for one share of Ferrari and ended up paying a price multiple of 30.9x!

Why is that so? Isn’t paying $155.8 for Ferrari is better and cheaper than paying $1,167.3 for Alphabet?

The secret lies to the earnings per share! Despite an “expensive” share price, Alphabet backs it up by having an earnings per share of $49.5! The result of it caused Alphabet to have a lower price multiple of 23.6x.

Now that you are comparing the share price relative to their earnings, you are making a fair assessment without jumping into conclusions.

The difference of knowing this concept of price multiple is the reason why many people succeed so much in investing. I cannot emphasize this enough. Your mind is the most valuable asset you have. Keep working on it and keep improving on it.

Conclusion

I understand there is wide range of readers, some of you may be experienced, some of you may be new. Nonetheless, I hope this simple article is useful for all of you.

Germaine is smart. Be like Germaine. 😝

This week, while I was conducting my workshop, one of you approached me and gave me your words of encouragement for my blog. I really felt your sincerity and kindness!

I hope to nurture genuine relationships with all of my readers. Please feel free to contact me on my Instagram (@kelvestor) or Facebook Page!

Now that you’ve mastered what is P/E ratio, I challenge you to read this article (How to Value Stocks? – P/E or EV/EBIT?) to push your understanding further!