understanding stock prices and values
The cheapest stocks—known as penny stocks—also tend to be the riskiest. A stock that has dropped from $40 to $4 may well end up at $0, while a stock that goes from $10 to $20 might double again to $40.
Some of these factors are common sense, at least superficially. A company has created a game-changing technology, product, or service. Another company is laying off staff and closing divisions to reduce costs. Which stock do you want to own?
You could be surprised. It pays to dig deeper. That game-changing company may or may not have a plan to build on its initial success. The markets have already priced in the value of that game-changing product. It had better have something good in the pipeline.
Most people believe a stock's value is indicated by its price. That's only true to a certain extent. There is a big difference between the two. The stock's price only tells you a company's current value or its market value.
So, the price represents how much the stock trades at—or the price agreed upon by a buyer and a seller. If there are more buyers than sellers, the stock's price will climb. If there are more sellers than buyers, the price will drop.
An investor can investigate a company to determine its value. All of the information needed is online in the company's public financial statements. Online brokerages offer analyses and summaries of those results from many sources. Take a look at the facts.
If a company’s share price plummets, its cost of equity rises, also causing its WACC to rise. A dramatic spike in the cost of capital can cause a business to shut its doors, especially capital-dependent businesses such as banks.
For example, if Company A has a $100 billion market capitalization and has 10 billion shares, while Company B has a $1 billion market capitalization and 100 million shares, both companies will have a share price of $10. But Company A is worth 100 times more than Company B.
One way in which companies control the number of available shares and how investors feel about their share price is through stock splits and reverse stock splits. Stock prices can have a psychological impact, and companies will sometimes cater to investor psychology through stock splits.
For example, many investors prefer buying stocks in round lots of 100 shares. A share price of more than $50 may turn off the average investor because it requires a cash outlay of at least $5,000 to buy 100 shares. That's a large financial commitment to make to one stock.
As a result, a company that has had a good run and has seen its shares rise from $20 to $60 might choose to do a two-for-one stock split. Now the stock looks like a bargain to new investors. But its intrinsic value didn't change.
A two-for-one split means that the company will double the number of shares that each of its current shareholders owns by simply dividing the current price of its shares in half. Two new shares will be exactly equal to one old share.
A new investor might be more comfortable buying the shares at $30, making a $3,000 investment to purchase 100 shares. Note that the investor could have bought 50 shares before the split, and had the same percentage ownership in the company for the same $3,000 investment.
This is why market capitalization is important. The company’s market cap will not change due to the split. If a $3,000 investment means a 0.001% ownership in the company before the split, it will mean the same afterward.
If a company’s share price drops to $6, it might counter this perception by doing a one-for-two reverse stock split. In this case, the company will convert every two shares of stock outstanding into one share worth $12 (2 x $6).
The principles are the same. This can be done in any combination—three-for-one, one-for-five, etc. But the point is that this does not add any true value to the stock, and it does not make an investment in the company more or less risky.
An example of a high price that may give investors pause is Warren Buffett’s Berkshire Hathaway (BRK.A). In 1980, a share of Berkshire Hathaway sold for $340.1 That triple-digit share price would have made many investors think twice.
Another example of a stock that has generated exceptional shareholder value is Microsoft (MSFT). The company’s shares have split at least nine times since its initial public offering (IPO) in March 1986.
Microsoft opened at $21 on its first day of trading.3 It was valued at $201.30 per share as of July 26, 2020.4 That seems like a decent return more than three decades later, but when all the splits are accounted for, a $21 investment in 1986 would be worth significantly more today. And, because the stock split, each share now also represents a much smaller piece of the company.
Investors use this financial data along with the company's stock price to see whether a company is financially healthy. The stock price will move based on whether investors are happy or worried about its financial future.
Similarly, related economic data, such as a monthly jobs report with a positive spin may also help increase company share prices. If the news is negative, though, it tends to have a downward effect on the share price.