By James Woolley
Many people who are very new to stock market investing are extremely naive when it comes to share prices and market valuations. This is perfectly understandable because no-one is an expert right from the start. However you do need to learn certain things before you start investing your money for real.
The point I want to make concerns the actual share price of a company. Some amateur investors automatically assume that a company’s shares are cheap just because their share price is very low. However this is a completely false assumption to make and has no basis of reality at all.
For example they may look at the list of FTSE 100 companies and automatically reject companies such as Rio Tinto and Randgold Resources because they both have very high prices of around 4500p and 5300p. They may instead prefer to look at stocks just as Royal Bank of Scotland and Lloyds, where the share prices are around 40p and 65p, just because they are a lot ‘cheaper’ and have much more potential to rise.
However, as I’ve already said, this is a crazy way of thinking. The truth is that it doesn’t really matter what the actual price per share is. It is the actual valuation that is important.
The valuation of a company is determined by it’s market capitalisation, and this is calculated by the number of shares issued multiplied by the current share price. So you can get a situation where a company with a very low share price can actually be a bigger company with a higher market capitalization than one with a much higher price. Indeed this is the case with Lloyds and Randgold, where the former is around 10 times bigger than the latter despite having a very low price per share.
As an investor you need to look at things like market capitalisation and price/earnings ratios amongst other things. If a company has a very low P/E ratio in relation to all the other companies in the same sector and is expected to grow in future years, then you could argue that it is currently quite cheap. It doesn’t matter at all what the actual share price is.
The point I want to get across is that the price per share could be 5000p or 50p, but the fact is that this doesn’t tell you anything about the company at all. You need to look at the actual earnings figures and the other financial data to start to get a good idea of whether a company is cheap or not. This may sound obvious to many seasoned investors, but you would be amazed how many people make this mistake when they first start investing their own money.
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