I have expensive tastes.
At least that’s what I’ve been told by members of the Albert Park Investors Guild. On more than one occasion, I’ve been asked why so many of my recommended stocks are ‘expensive’.
At first, I got a bit defensive. While I don’t consider myself strictly a ‘value investor’ — that is, an investor who identifies cheap stocks that have been mispriced by the market — I do a pretty good job of avoiding expensive stocks. Or so I thought. I do a huge amount of analysis to make sure I don’t recommend overpriced companies. Many are large, well-known, established global businesses. Companies with household names that get plenty of coverage from analysts, which often means they are priced fairly by the market.
I soon realised that they meant was I recommending stocks with high dollar values. One of my recommendations is trading at $127 per share, another at €124 per share, and another US$98.
There seems to be some confusion over what makes a stock expensive, or cheap.
Imagine it this way. You’re hungry for a pizza, so you head down to the local pizza shop where you can get a large pizza with six slices for $15. Across the road is another shop selling the same sized large pizza also for $15, but it has eight slices. Now tell me, which is the better value?
I hope you can see that they are equal value. Six large slices is the same amount of pizza as eight smaller slices. A large pizza is a large pizza — it doesn’t matter how it’s cut.
Well, the same is true for share prices. If you invest $10,000 in a company, it doesn’t matter if each share costs $100 or $2. That $10,000 will buy you 100 shares of the $100 per share stock, or 5,000 shares of the $2 stock.
A $100 stock isn’t necessarily more ‘expensive’ than a $2 per share company. The $2 stock might be overvalued, while the $100 stock might be undervalued.
Let me make this clear: Stocks with small dollar prices are not cheaper than stocks with a large dollar prices. Just looking at the share price doesn’t give any indication whether a stock is expensive or not.
Another common belief is that a $20 stock is more likely to rise $4 – for a 20% return, than a $200 stock is to rise $40. This is not true.
The actual dollar price means very little.
It’s true that many small companies have low priced stock. And small companies tend to be more volatile. Share prices of just a couple of cents often trade on low volume. There is often less information available on them and less coverage by analysts. So they are more likely to be EITHER overvalued or undervalued.
However, low prices don’t always mean you are dealing with a small company. Telstra, for example, is worth $77 billion, but it has a share price of just $6.23. While, Macquarie Group, a much smaller company of $19 billion, has a share price of $60.20 per share.
How then can you tell if a company is cheap?
To find whether a stock is expensive you need to look at a variety of metrics. Most are calculated on a per share basis, which makes it easier to compare to the share price. A popular one is the price to earnings (PE) ratio. It compares a company’s earnings, on a per share basis, to the share price. It shows how much it costs to buy a share of a company’s profits. A lower PE usually suggests better value.
A word of caution though. You should only compare similar companies — average PE ratios can vary a lot from one industry to another.
The PE ratio is just one of the ways to check the value of a company’s shares. Don’t use it in isolation, or make decisions by simply comparing PE ratios.
The real value of a stock goes beyond the current share price. The true value includes the future prospects of the company. Things like the quality of the management team, and external economic and political influences, all affect future value. Even if a stock looks expensive today, there could be good reason for its high price.
Expensive stocks often have good reason to be expensive — they are high quality businesses that are recognised as such by the market. Remember that by expensive, I mean that they trade on a high multiple to earnings — not that they have a large share price.
It is important to not pay too much. But don’t worry about the per share price, or the number of shares you buy. Just decide how much money you want to invest.
Value is just one factor I look for when analysing investments. There are many other things to consider that are as equally, or more, important. These are listed in special report available to Albert Park Investors Guild members. If you’d like to know more, this is a great place to start.
for The Daily Reckoning Australia