Why a Price of a Stock, Doesn’t Determine Its Value

A common misconception among new investors is that a high stock price means the stock is overvalued, and a lower stock price means it’s a bargain. For example, some might think, “I’m not buying that stock because the price is too high. It’s better to invest in cheaper stocks.” However, this isn’t always the case.

The Price vs. Value Misconception
Consider Google, which might be trading at $1,200 per share. Some might think this price is too high and has a higher chance of coming down. But the stock price alone doesn’t determine whether it’s a good investment.

Take Berkshire Hathaway (BRK.A) as an example. In 1982, it was selling for $485 per share. By 1992, it had risen to $10,000 per share, and by 2002, it was $70,000 per share. In 2012, it reached $120,000 per share, and by 2019, it was over $300,000 per share. Was it overpriced at $485 in 1982? Even after accounting for inflation, it provided an excellent return.

Understanding Market Capitalization
To grasp this concept, you need to understand the relationship between stock price, outstanding shares, and market capitalization. This will help you see how the per-share price is calculated versus the company’s overall value.

Example:
Company A: Valued at $1 million (Market Cap)

Shares Outstanding: 10,000

Price per Share: $1,000,000 / 10,000 = $100

Company B: Also valued at $1 million (Market Cap)

Shares Outstanding: 100,000

Price per Share: $1,000,000 / 100,000 = $10

Both companies are valued at $1 million. This doesn’t mean Company A is overpriced or Company B is a bargain. It also doesn’t mean Company A has a higher chance of coming down or Company B has a higher chance of going up.

Conclusion
When evaluating stocks, don’t rely solely on the stock price. Consider the company’s market capitalization, outstanding shares, and overall value. This approach will help you make more informed investment decisions and avoid common misconceptions.