Stock Market Share Prices

We all look at stock market share prices and wonder what they mean. Sometimes, when we see a stock that we know is a large and powerful company and compare its price to a smaller company, we are surprised by the result. How can a juggernaut like Starbucks or Walmart cost less than a local utility or another much smaller company? The key to understanding this mystery is: Share prices are not correlated with company prices.

To understand why this is, you have to remember something. A share price is just that, the price per share. That number is meaningless without a second number, the number of shares. The multiplication of the number of shares times the price per share yields a number called market capitalization, which is the actual value of the company. If you wanted to buy Walmart, you would have to buy all the shares; this would cost you much more than your local utility, because it has issued fewer shares.

The implications are huge. You can’t really tell anything just from share prices. Walmart is currently trading at around $50 per share. If they split their stock by a factor of 10, giving everyone who has one share 10 to replace it, the share price of Walmart would suddenly be $5; but the market capitalization wouldn’t have changed, and Walmart wouldn’t be any cheaper.

A popular method of determining the appropriateness of a share price is a price to earnings ratio. To achieve this ratio, you simply divide the price per share by the earnings per share. Since both of these numbers are in per share terms, you are left with a ratio that doesn’t depend on the number of shares. This tells you how much the company is trading at in relation to how much it is earning. This makes sense since the value of a company comes largely from its ability to generate income, but of course stock analysis is much more complicated than that.

There’s no one “correct” price earnings ratio. Over time, average price to earnings (P/E) ratios have varied from as high as 30 or 40 during booms, to as low as 5 or 10. In recent history a rule of thumb has been that a 15 P/E ratio is in the right area, however that hasn’t been the average in the S&P 500 since 1990, so that heuristic may be out of date.

As you can see, assessing stock market share prices can be very complex. There are many ways to look at a stock, however the most important lesson is this: A share price means nothing on its own. While it is an important part of deciding whether to buy a stock, there is much more to learn.