Why Stock Price Doesn’t Determine Value: A Guide for Novice Investors

A common misconception among novice investors is:

I am not buying that stock because the stock price is too high. It’s better to invest in stocks with a cheaper stock price. For example, Google is trading at $500 per share (not to mention splits), and it’s too much; it has a higher chance of coming down.

It’s crucial to understand that Google may or may not be worth $500 per share, but you shouldn’t determine its value based solely on its price.

Consider Berkshire Hathaway (BRK.A). In 1982, it was selling for $485 per share. At that time, $485 was a significant amount of money for a share, and many might have thought it was too expensive to buy. However, by 1992, it was selling at $10,000 per share, in 2002 at $70,000 per share, in 2012 at $120,000 per share, and in 2019, it was selling for over $300,000 per share. Was it overpriced in 1982 at $485? Even accounting for inflation, it provided an excellent return!

To grasp this concept, you need to understand the correlation between stock price, outstanding shares, and market capitalization. This will show you how the per-share price is calculated versus the company’s value. Let’s take two companies as examples:

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

This company offers 10,000 shares to the public (shares outstanding).

Thus: $1 million / 10,000 shares = $100 per share.

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

This company offers 100,000 shares to the public.

Thus: $1 million / 100,000 shares = $10 per share.

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