Many beginning investors make the mistake that the price of a share matters a lot. In reality, the price of a share doesn’t matter all too much at least by itself. Large numbers might make a company seem more valuable but it is very possible that the company is less expensive than one with a single-digit share price. In this post, I’ll go over what role in the valuation of a company does share price have and other factors that contribute to valuation.
Disclaimer: None of what I’m talking about should be considered as financial advice. It is for entertainment and educational purpose only.
Market Capitalization Is What Matters
The price of a share alone is not able to help you determine if a company is expensive or not. When you’re trying to figure out if a company is expensive or not you’ll have to look at the market capitalization. So, what exactly is the market capitalization (market cap) of a company? The market cap is the total dollar market value of a company that is derived from the total number of outstanding shares and the price per share.
Another way to look at is this simple formula:
market cap = number of shares x price a share
Without knowing the market cap it is difficult to tell if a company is expensive, fairly priced, or undervalued.
Companies Can Go Up in Value With Price Being Stagnant
There is a possibility that the price can stay roughly the same while the market cap keeps increasing. If all you pay attention to is the price, then you’ll miss the details that the company’s valuation is growing. From the equation to calculate market cap, you know that it’s a relationship between the number of shares and the price of a share. Since the price is not changing that means the number of shares is going up.
Companies can raise capital to operate by offering more shares in the market. Whenever such a case happens, it is a share dilution, where each share will have less ownership of the company. Ideally, after a share dilution, the price of shares tends to adjust to maintain the same market cap.
Long-Term Investment Focus on Market Capitalization
When it comes to long-term investing, the focus should be on the total addressable market (TAM) and the market cap. The larger the TAM, the larger the market cap of a company can get while having a reasonable slice of the pie.
Take for example the TAM starts at 10 billion for a relatively new industry and a company makes up 50% of it. The company would have a market cap of 5 billion in this case. Over time let say the TAM grows to 50 billion and the company becomes 30% of it due to new companies entering the market. While the overall percentage of the company lowered, it is still at a 15 billion market cap. By the equation to calculate the market cap, you can figure out that the price of a share must have gone up assuming no new shares were introduced.
From just the share price alone, it would be impossible to figure out what is going on. The price of shares could have gone up due to the expansion of the TAM or a reverse stock split. An increase in price due to TAM expansion is a good thing. While a price increase due to a reverse stock split is a bad thing.
At the end of the day, the price of a stock only gives you half of the picture. With just the price alone it is difficult to know if your company is doing well or not. To get a better full picture of your company, you’ll need to look at the market capitalization. The market capitalization is the number of outstanding shares times the cost per share.
I hope this post was helpful to you. If you found this post helpful, share it with others so they can benefit too.
If you’re new to investing and need a guideline to help you start your investment journey you can check out my post on setting yourself up for financial success. I also have a post about beginner mistakes to avoid in the stock market.
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