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Why the Dollar Price of a Stock Does Not Matter

When first starting to invest in stocks, it is a common occurrence to see novice investors shy away from issues with high dollar prices. The primary reason for this is simple psychology. If that investor is starting out with, say, $5,000 to invest, he or she will only be able to buy 10 shares of a stock like Google (GOOG), but could buy nearly 350 shares of competitor Yahoo! (YHOO). Furthermore, the psychology is such that this investor realizes that small monetary gains in each share benefit him more with the lower-priced stock. A $1 move in YHOO (currently at $14 and change) would have to be matched by a nearly $32 move in GOOG to have the same net effect. And it seems much easier to get that $1 appreciation than $32.

The most important psychological factor for a novice stock investor, though, is the lack of understanding of how valuable a single share of stock is. If he or she sees a share of GOOG stock vs. a share of YHOO stock as equivalent, the nearly 32x cost of that share of GOOG seems very expensive to pay. While this same investor may have a background in technology, and understand that Google is a better-performing company than Yahoo!, the magnitude of difference in their stock prices may not be immediately understood.

Of course, experienced investors know that it is not the dollar price of a stock that matters, but the dollar price of the entire company, also known as "market capitalization". When you buy a share of stock, you are buying a piece of the company. Where Google and Yahoo! differ are in the number of pieces of the company they offer to the general public, also known as "outstanding shares" or "public float".

Sticking to our example, Google has broken the company into about 319 million shares. When you multiply these shares buy the price per share, also known as the stock price, you get a market capitalization of about $146 billion dollars ($454 x 319). This is the theoretical price for you to buy the entire company.

Yahoo!, on the other hand, has broken their company into much tinier pieces, with 1.39 billion shares outstanding. This puts their market capitalization at about $19.5 billion ($14 x 1390).

Now that we are comparing apples to apples, we see that Google is roughly 7.5 times more expensive than Yahoo!, instead of the 32x difference in the per-share stock price. This is the starting point for deciding how expensive a company is - investors should always approach stocks as if they were purchasing the entire company.

But we are not done yet! If we were theoretically going to buy the entire company, we should account for both the cash on hand and debt that each firm has. After all, if a company has a lot of cash, we would effectively be getting some of our money back right away. On the other hand, if we buy a company with a lot of debt, that adds to the purchase price as we would be assuming responsibility for paying it off.

To account for this, we simply add debt and subtract cash from the market capitalization to get a number known as "enterprise value" (EV). In Google's case, the company holds a massive $26.5 billion dollars in cash on its balance sheet, and no debt. For Yahoo!, $3.2 billion in cash, but with about $136 million in debt. Let's apply these to get an enterprise value for each firm:

Google: 146,000 + 0 (debt) - 26,500 (cash) = 119,500 million enterprise value.
Yahoo: 19,500 + 136 (debt) - 3,200 (cash) = 16,436 million enterprise value.

Doing this, the two companies are a bit closer, with Google being worth 7.2 times Yahoo. Enterprise value doesn't make a big difference in this example, but it can produce drastically different valuations than using market cap for many firms (for better and worse). Always use EV instead of market cap.

The last thing to cover here is: what kind of value am I getting from the current enterprise value of the two stocks?

If we use a car analogy, it's easy to understand why two companies with similar businesses like GOOG and YHOO sell at such wildly different valuations. Take, for example, a Chevrolet Aveo and an Audi R8. Both are vehicles. Both have 4 tires, an engine, steering wheels, etc. Now, if I offered to sell you the Aveo for $20,000 and the R8 for $75,000, which would be the better value?

You cannot make a proper decision without knowing what determines the value of a car. You have to consider engine type and power, acceleration, top speed, styling, materials, handling, cache, etc., in order to make a decision. In this case, the R8 for $75,000 is a much better deal. It has a 420hp engine, a luxurious cabin, head-turning styling, etc. The Aveo, on the other hand, is an economy 4-door. When you know the list price of each, the value proposition is clear. The list price of the R8 is about $115,000, while the list price of the Aveo is closer to $13,000. At my prices, you would be overpaying for the Aveo by over 50%, while my price for the R8 is a 35% discount to its true value.

What an investor needs to do is determine what the "list price" for a stock should be - generally called "fair value". Like cars, this is a function of specific characteristics of the underlying business, notably growth potential, competitive position, financial health, business momentum, sales, net assets, and most importantly, profits.

This in mind, let's compare GOOG and YHOO on some common stock "sticker specs":

Sales: $24.9 billion (GOOG) vs. $6.5 billion (YHOO) - 3.8x difference
Net Profit ("earnings"): $7.1 billion (GOOG) vs. $790 million (YHOO) - 9.0x difference
Net Assets ("book value"): $32.3 billion (GOOG) vs. $8.5 billion (YHOO) - 3.8x difference
Growth Rate: 17% (GOOG) vs. 14.8% (YHOO)

The relative value is normally conveyed by dividing the enterprise value by these figures. The resulting ratios (EV/sales, EV/earnings, EV/book) give you an idea of the relative value of the stock prices. The lower the ratio, the better value the stock price:

EV/sales: 5.0 (GOOG) vs. 2.7 (YHOO)
EV/earnings: 17.6 (GOOG) vs. 21.9 (YHOO)
EV/book: 3.8 (GOOG) vs. 2.0 (YHOO)

From these statistics, we see that Yahoo! is cheaper by every metric except the most important one: earnings. From there, it becomes a qualitative exercise of determining which company has the better future prospects.

Remember, it's not the dollar price of a stock that matters - it is how far that dollar price is under a reasonable "list price", or fair value, of the company based on its component characteristics that determines true value.

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