The Correct Way You Should Think About Stock Prices
Looking at a stock based on stock price alone is a lot like buying a car without knowing anything about the car. If you walk into a car lot and car A is $10,000 and car B is $30,000 which one would you buy? You could argue and say car A is better value because it’s $20,000 less than car B but what you didn’t know is that car B was a Bentley being sold at a great value. The same type of thing happens when you just evaluate a stock based on share price alone. This is why you need to look at other information.
See the quickest way to evaluate a stock.
The investor must ask himself which is better – paying $50 for $1.48 in earnings, or paying $25 for $0.74 in earnings? Neither! In the end, the investor comes out exactly the same. The transaction is akin to a man with a $100 bill asking for two $50’s. Although it now looks like he has more money, his economic reality hasn’t changed. This, incidentally, should prove it is pointless to wait for a stock split before buying shares of a company.
For a quick evaluation of stock say you have company ABC earning $1 per share at a $10 share price and company XYZ earning $3 a share at a $15 share price. If you buy company ABC you are paying $10 for every $1 in earnings. If you buy company XYZ you are paying $5 for every $1 in earnings which is a far better deal! (This is also called the P/E ratio or Price to Earnings ratio). When using this type of quick analysis you want to look at other competitors in the industry that way you can see if your stock is overvalued or undervalued vs competitors. Comparing a banking stock to a tech stock using this method is like comparing apples and green beans. It just doesn’t make any sense.
About Shaun Archer Tatum Shaun works in corporate finance in New York City. He has done financial consulting for several start-ups and has worked at several Fortune 500 companies. He has contributed several finance/investing articles on Seeking Alpha which have been published on Yahoo! Finance.