One Common Myth About Stock Prices

OneHave you heard of the term “penny stock”? This is a term used to describe  a stock that’s trading at a very low price, normally below the dollar mark, andsome investors tend to think of them as carrying higher risks..

On the other hand, stocks with high prices in the double digits, such as DBS Group Holdings (SGX: D05), Jardine Matheson Holdings (SGX: J36), United Overseas Bank (SGX: U11), might tend to give investors a sense of  security and safety.

But, does the price of a stock really indicate how risky a company is?

How is a stock price determined

Why is Jardine Matheson trading at US$51.50, while  UOB is selling for half the price at S$ 20.68 when both companies have a similar market value as of 20 Dec 2013?

This is because the price of a company’s stock is calculated by dividing its market value with the number of shares outstanding.

In this case, Jardine Matheson has about 680 million shares outstanding while UOB has more 1500 million shares outstanding. Notice how there is no mention of risk in the calculation of the price of a stock.

How a company can change its price without changing its market capitalisation

Keeping its market value constant,  a company can quite easily change the price of its stock by altering the number of its shares outstanding.

One of the most common ways of doing so is via a stock split: A company can double the number of its outstanding shares by splitting each share into two.

In so doing, theoretically, the price of its  stock will be reduced by half as its market value should not be affected by this corporate exercise. We can also see that the investment risk present in a company has not been changed at all in a stock split, as the fundamentals of its business has not been altered in any way.

Foolish Bottom Line

Although all the 30 constituents of  the Straits Times Index (SGX: ^STI) are trading at different prices, it tells us nothing about the riskiness of each company and its business.

Instead of basing our investment on the price of a stock alone, we may all gain from taking a more business-like approach. As Benjamin Graham, the father of value investing, once said, “Investment is most prudent when it is most business-like.”