Is the Share Price Cheap or Expensive?

It depends on who you ask.

What is Share Price?

Firstly, let’s clarify what the share price is. One of the two ways a company gets money for its business is by selling pieces of itself to investors. Each piece is called a share or a stock in the company. The company decides by itself, how many pieces, or shares, it wants to create, who gets to own these shares and if any of these shares are more ‘special’ than others.

If the company is a lemonade stall business owned by 3 kids and all 3 kids have equal ownership of the stall, the company could create just 3 shares (each kid owning one share) or 3,000 shares (each kid owning one thousand shares).

The share price is the price paid for one share of the company. Back to the lemonade example, each kid owner may put in $100 of his own money to start the lemonade business. If each kid owner has one share, then the share price is $100. If each kid owner has one thousand shares, then the share price is $0.10 ($100 divided by 1,000 shares).

The key point here is that the share price itself is meaningless because it depends on the number of shares the company created. What is important is the value of the business, which at the start is $300 representing the total amount of money the 3 kids had put in to start the business. This $300 is also known as the shareholder’s equity in the business.

How the Share Price Can Change

For simplicity let’s assume that the company created 3,000 shares. Each share is thus worth $0.10.

Imagine that the lemonade business goes wildly successful and makes $300 in net profit in its first year of operation. The value of the business (from a shareholder’s equity perspective) is now doubled to $600 comprising of $300 which was initially put in to set up the business and $300 from its first year’s net profit that the owners decided to retain within the company.

The share price is still $0.10 since no shares have been bought or sold by the founders. On paper, the share price is cheap because the value of the business has doubled but the share price remain the same.

This success doesn’t go unnoticed and soon other kids in the neigbourhood want a part of it. Five kids want to give $100 each to the lemonade business. The owners decide that since they are the founders of the lemonade business they should always own the majority of the shares and keep control of the business. The 5 kids and their $500 will only be entitled to 20% of the lemonade business.

How does the company give the 5 new kids 20% of ownership for $500? It takes their money and simply creates new shares out of thin air – 750 new shares since it originally had 3,000 shares with the 3 founders. This means the total number of shares created now is 3,750 where 3,000 (80%) belongs to the 3 founders and 750 (20%) is distributed equally amongst the 5 new kids.

The value of the 750 shares is $500 and as a result of this transaction the share price is now worth approximately $0.67 ($500 divided by 750 shares). This is much higher than the $0.10 share price that the founders enjoyed prior to giving the 5 new kids a 20% stake in the business.

Cheap or Expensive Depends On The Expected Returns

Is the share price $0.67 cheap or expensive? What does a $0.67 share price mean?

At approximately $0.67 a share, the lemonade business with 3,750 shares is valued at $2,500 ($0.666.. x 3,750 = $2,500). To the 5 new kids/investors, this may seem reasonable since each year the business is capable of earning $300. $300 a year for a business worth $2,500 is a 12% return ($300 divided by $2,500) and this may be good enough for the 5 new kids.

What do the 3 original owners think? Surely they must be happy because the share price of the company jumped from $0.10 to $0.67 with the investment from the 5 new kids. But the company was giving them a 100% return initially ($300 a year net profit on their $300 initial investment). Now with the higher share price, the return is just 12%. For them, paying $0.67 a share is expensive because the returns has been greatly reduced.

Now let’s take this example further with one of the founders selling out part of his stake to yet another investor for $1.00 a share. When the shares are transacted at the price of $1 a share, it values the lemonade business at $3,750 ($1 x 3,750). This new investor has a modest expectation and a return of 8% ($300 divided by $3,750) is good enough. Is $1 a share now expensive? Not if you ask the new investor who just paid this price. However to the investors that got in earlier, it may appear expensive.

Applying this knowledge to the Real World

In the stock market, it is easy to know the current share price. Whether it is cheap or expensive depends on the returns you are looking for. On all stock websites and trading apps, there will be a P/E (price to earnings) ratio for every stock. This ratio takes the current share price and divides it by the earnings (net profit) per share.

In other words, it takes the value of the company (share price x total number of shares) and divides it by the yearly earnings (net profit). Flipping it around (yearly earnings divided by the value of the company) gives you the returns. A P/E value of 10 means a returns of 10%, while a P/E value of 20 means a returns of 5%.

Shares of some companies have insanely high P/E ratios. This is mostly because there is an expectation (that is reasonable or otherwise) of very high future growth of the company’s earnings. Nvidia currently has a P/E ratio of around 120, which is equivalent to a 0.8% return. Compare this with money market funds and US treasuries that have over 4% returns. An investor who is planning to hold Nvidia shares for the long run will find the shares expensive at its current price.

(Now I need to qualify that there are stock traders who do not hold shares for the long run. They buy and sell shares based on where they think the ‘herd’ is moving so the share price is not important. What is important is that they can profit from the short term up and down movements of the share price.)

In reality, a company with strong earnings and market dominance will have expensive shares. Similarly a company with suspiciously cheap shares could mean it has trouble ahead. There are no free meals in this world. However, once in a while, an event could crash the stock market and the shares of all companies, good and bad go on a massive sale. That would be the best time to pick up on shares that would be relatively cheaper.