What Really Makes A Stock Price Expensive?

A stock with a seemingly higher share price is not necessarily more expensive than others and vice versa.

Imagine you had N1000 to invest in stocks. Will you opt for N10/share of one company and have 100 shares in the company or will you invest in another company whose shares go for N200/share and have only 5 shares in the company?

Whatever your answer might be, the real truth is that you don’t know. You don’t have enough information to make such decision because you don’t know the true value of each of the shares. N200/share is not necessarily expensive and N10/share is also not necessarily cheap.

This too is part of the relativity of share price.

Looking at only the share price of a company is not enough information or data to make the decision of whether an investment is good or bad. Trying to get as many shares in a company is not necessarily a better investment strategy that guarantees great returns.

A stock with a seemingly higher share price is not necessarily more expensive than others and vice versa. Understand that the share price of any company’s stock is completely dependent on the number of shares the company has outstanding and its market capitalization which is essentially how much it will cost to purchase the entire shares of a company at a given period of time.

Your investment in the business is what determines the percentage claim you have of it. A good way to understand this is that 10% in a 1 billion Naira business is always going to be worth more than 50% in a 1 million Naira business. Since share price can be deceptive, there must be added value being proposed by the potential investment company.

So how do you accurately determine if a company’s price is expensive?

The company itself. This is where there is a need to carry out a fundamental analysis of the company you want to invest in. If a company’s share price is overvalued, chances are that it will crash and it wouldn’t matter how much you got it at.

A good metric to use to determine this is the Price to Earnings ratio, typically known as the P.E ratio. This ration basically tells you how much investors are willing to pay (price) in comparison to the earnings per share of the company (earnings).

The way to determine the expense is that the higher the PE ratio, the more expensive a stock's market value is relative to its value based on how it performs.

What this means is that in a situation where a company's earnings stays constant and the price per share keeps rising, the price to earnings ratio keeps increasing and the value to be made per the cost of purchasing it will now keep reducing.

It will rise to a given point until the price is just too expensive for its earnings and this is the point many investors are forced to cut their losses and sell.

The point here is to understand that looking at the face value of share price before making an investment decision is not a credible way to determine whether the share price is too expensive or not. The price must be compared in relation to the value before the true cost can be determined.

Written by Lawretta Egba.