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Stock Prices Fooling US For Correction?

|Includes: ProShares UltraShort Financials ETF (SKF)

Ross Aldridge in Las Vegas Nevada reviewed Wayne Pinsent's observations and concurred with the old adage, "Don't judge a book by its share price!

A common saying says, "Don't judge a book by its cover." Some equally valid words of wisdom for investors could be, "Don't judge a stock by its share price." Despite much readily available information for investors, many people still incorrectly assume that a stock with a small dollar price is cheap, while another with a heftier price is expensive. This misconceived notion can lead investors down the wrong path and into some bad decisions for their money.

The cheapest stocks - "penny stocks" - also tend to be the riskiest. That stock that just went from $40 to $4 might end up at zero. And a stock that goes from $10 to $20 might double again to $40. Looking at a stock's share price is only useful when taking many other factors into account.

Many Factors to Consider
Investors often make the mistake of looking only at stock price, because it is often the most visibly quoted number in the financial press. However, the actual dollar price of a stock means very little unless many other factors are considered. 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.

A stock with a $100 share price may be intimidating to many retail investors, because it seems very expensive. Some investors think that a triple-digit share price is bad, and they feel that a $5 stock has a better chance of doubling than the $100 stock. This is a misguided view, because the $5 stock might be considerably overvalued, and the $100 stock undervalued. The opposite also could be true as well, but share price alone is no sign of value. Market capitalization is a clearer indication of how the company is valued, and gives a better idea of the stock's value.

Why Market Cap and Share Price?
Stocks are divided up into shares so that clearly distinguishable units of the company and investors can buy a portion of the company corresponding to a portion of the total shares. The actual number of shares outstanding for publicly listed companies can vary widely.

Big examples of this are stock splits and reverse stock splits. There are some psychological associations with stock prices, and companies will sometimes choose to cater to this investor psychology through stock splits. For example, people tend to prefer buying stocks in round lots of 100 shares. This leads to the conclusion that a stock with 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. This is a large financial commitment to make to one stock for the average retail investor. 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 2-for-1 stock split.

Stock Splits
A 2-for-1 split means that the company will change every share of stock into two. It also means that the value of each share will be divided in half, so that the two new shares will be exactly equal to the one old share. An investor might be more comfortable buying the shares at $30, making a $3,000 investment to purchase 100 shares, but the rationale is absent when looking at the actual transaction.

When the investor buys the stock after the split, 100 shares constitute a $3,000 investment. However, the investor could just as easily have bought 50 shares before the split, made the same $3,000 investment and had the same percentage ownership in the same company. This is why market cap is important. The company's market cap will not change due to the split, so if a $3,000 investment means a 0.001% ownership in the company before the split, it will mean the same afterward.

Reverse Splits
A reverse split is just the opposite. Some investors think that stocks that are less than $10 are riskier than stocks with double-digit share prices. If a company's share price drops to $6, the company can counter this perception by doing a 1-for-2 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 - 3-for-1, 1-for-5, 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 - all it does is change the share price.

Real World Example
An example of where a high price may have made investors pause is Warren Buffett'sBerkshire Hathaway (NYSE:BRK.A). In 1980, a share of Berkshire Hathaway sold for $340. The triple-digit share price would have made many investors think twice. However, Berkshire Class A shares are worth $173,300 each in 2013. The stock rose to those heights because the company, and Buffett, created shareholder value. At $173,300 per share, would you consider the stock expensive? The answer to that question does not depend on the dollar price of the shares.

Another example of a stock that has generated exceptional shareholder value is Microsoft(Nasdaq:MSFT). Microsoft's shares have split multiple times since its IPO in March 1986. Microsoft closed at $27.75 on its first day of trading, and is currently valued at $32.93 per share in 2013. That seems like a meager return over 20 years, but when all the splits are accounted for, a $27.75 investment in 1986 would be worth significantly more today. Because the stock did split, the share price in 2013 was $33, but each share also represented a much smaller piece of the company.

Microsoft and Berkshire both produced stellar returns for investors, but one decided to split several times, while the other did not. Does this make one more expensive than the other now? No - if either should be considered expensive or cheap, it should be based on the underlying fundamentals, not the share prices.

When Does Price Matter?
Share price can have a big impact on a company. There are the psychological implications to the market mentioned above, but there are also real implications that can affect a business's solvency. Companies can raise cash through equity or debt. The weighted average cost of capital (OTC:WACC) is a weighted average of a company's cost of debt andcost of equity. If a company's share price plummets, its cost of equity rises, also causing its WACC to rise. A dramatic spike in cost of capital can cause a business to shut its doors, especially capital-dependent businesses like banks. This problem was in the spotlight during the 2007-08 credit crisis, and should be on the minds of investors following a sharp stock decline.

Ross Aldridge in Las Vegas Nevada Concluded:
Some investors may focus on share price when looking at a stock, because it is the most visible number in the financial press. Investors should not get fixated on share price alone, because companies can change share prices dramatically through stock splits, reverse splits and stock dividends without changing fundamentals. Dig a little deeper when thinking about your next investment, and remember that a stock with a high price can go much higher under the right circumstances, just as a stock with a low price can sink even further if it isn't really a good value.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SKF over the next 72 hours.