How to Understand Stock Prices

A stock’s price could indicate nothing about its intrinsic value. We look at the basics in how to assess share prices

Ruth Saldanha 23 September, 2020 | 11:22AM

Sales!

A reader recently wrote in asking for some advice on her stock portfolio. Her husband had just died, and she wanted to know which of his stocks she should hold and which she should sell. She wrote, “I feel I should sell the cheap ones, especially the ones below $20 per share or so?”

She isn’t alone in her misconception of stock prices. Many investors assume that if a stock price is low, it is cheap, and that if a price is high, the stock is expensive. The assumption here is that the stock's price is an accurate reflection of the value of a company.

Without context, non-investors will likely assess a stock price in the same way they assess the price of any other consumer good, for example, shoes. You can get a pair of trainers for £20 or you could get shell out for the Nike MAG Back to the Future trainers, which go for around £24,000. We can agree that £20 trainers are inexpensive and £24,000 ones are very expensive. This is because our concept of the value of something is based on our ability to gauge price versus value for consumer goods. We think harder about spending £1,000 on a physical thing (or service) than we do about spending £10.

Oscar Wilde Quote Price Value

Because we think like this and make these judgments often in our daily lives, it is natural for us to extend this logic to stocks. To our minds, a stock under £10 is cheap, while one over £1,000 is expensive.

But this is just not true.

What is important about understanding stock prices is that stocks are not like any other product or commodity we buy. The only thing the price of a share in a company and the price of a consumer good have in common is the unit of measurement in which they are expressed.

A company is cheap, or undervalued, when the share price is lower than its intrinsic value. On the flip side, a company is expensive, or overvalued, when the stock price is higher than its intrinsic value.

Let’s break that down to understand what each of these terms mean.

What is a Stock or Share?

When you own a share of a company, it means you are entitled to own a share of that company’s future profits (or, in the case of a liquidation, a share of its remaining assets).

You can own a share in a company even if its shares are not publicly traded. Family businesses work exactly this way, for example: family members own a certain share of the business, which is usually expressed as a percentage. In private company legal documents, though, the ownership is expressed in shares, just as with publicly traded companies.

Publicly traded companies usually have millions of shares outstanding. The percentage you own of the company is simply the number of shares you own divided by the total shares outstanding. Shares outstanding can be found on every company profile page on Morningstar.

What is a Stock (or Share) Price?

A stock price is the price of a single share of stock of a company.

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The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Ruth Saldanha

Ruth Saldanha  is Senior Editor, Morningstar.ca

 

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