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Saturday, September 29, 2012

Why Share Price is not Important?

Why is a stock that cost Rs. 50 cheaper than another stock priced at Rs. 10?

This question opens a point that often confuses beginning investors: The per-share price of a stock is thought to convey some sense of value relative to other stocks. Nothing could be farther from the truth.

We do receive many queries over mails about investing in low priced penny stocks. Investors many time looks at low price stock to decide whether to buy or sell. There is a myth that if price is low, there are better changes for the scrip to go up.

Suzlon Energy which made all time high of Rs. 440 (adjusted price) on 09 Jan'12 is now available at Rs. 18. Investors ignoring fundamentals and looking at high / lows of scrip invested in Suzlon at Rs. 100 and later in the range of Rs. 40-50 thinking its cheap looking at price and finally getting trapped. There are many such stocks like Lanco Infratech, GVK Power etc. No doubt, these are good companies but valuations based on fundamentals are not attractive for investment. Why share holders will stay invested in such companies knowing the fact that these companies are debt ridden and would not be able to generate free cash flows atleast for next 4 to 8 quarters.
In fact, except for stock price to be used in some calculations, the per-share price is virtually meaningless to investors doing fundamental analysis. If you follow the technical analysis route to stock selection, it’s a different story, but for now let’s stick with fundamental analysis.

The reason we aren’t concerned with per-share price is that it is always changing and, since each company has a different number of outstanding shares, it doesn’t give us a clue to the value of the company. For that number, we need the market capitalization or market cap number.

The market cap is found by multiplying the per-share price times the total number of outstanding shares. This number gives you the total value of the company or stated another way, what it would cost to buy the whole company on the open market.

Here’s an example:

Stock price: Rs. 50

Outstanding shares: 5 Crores 

Market cap: Rs. 50 x 50,000,000 = Rs. 250 Crores

To prove our opening sentence, look at this second example:

Stock price: Rs. 10

Outstanding shares: 30 Crores 

Market cap: Rs. 10 x 300,000,000 = Rs. 300 Crores

This is how you should look at these two companies for evaluation purposes. Their per-share prices tell you nothing by themselves.

What does market cap tell you?

First, it gives you a starting place for evaluation. When looking a stock, it should always be in a context. How does the company compare to others of a similar size in the same industry?

The market generally classifies stocks into three categories:

• Small Cap under Rs. 1000 Crores 

• Mid Cap Rs. 1000 - Rs. 10000 Crores

• Large Cap - Rs. 10000 Crores

Some analysts use different numbers and others add micro caps and mega caps, however the important point is to understand the value of comparing companies of similar size during your evaluation.

You will also use market cap in your screens when looking for a certain size company to balance your portfolio.

Don’t get hung up on the per-share price of a stock when making your evaluation. It really doesn’t tell you much. Focus instead on the market cap to get a picture of the company’s value in the market place.