So here’s the setup: you have two large pizzas. One is cut into four pieces, the other is cut into eight pieces. Would you rather have one piece from the former, or two pieces from the latter? If you asked a hungry four-year-old that question, he’d probably be totally confused because you used the words “former” and “latter.” But then he’d go for the 2 pieces because in his mind, two pieces are more than one. Of course, anyone with a basic knowledge of fractions knows this is a trick question, because it’s the same amount.
Let’s imagine now that the pizzas are companies, and the pieces are shares of stock in those companies. You have $1000 to invest. Company A’s stock price is $50, and company B’s stock price is $100. Assuming that there are no trading costs, you can purchase 20 shares of company A and 10 shares of company B. All else equal, which would you buy? Answer: it doesn’t matter – your investment in either company is the same. Really. You’d be surprised at how many otherwise intelligent people would choose company A because you get “more” shares of stock or because they think the shares are a better “value” by virtue of having a lower price per share. The thing you have to realize is this – a company can issue any number of shares it wants to. If the price per share is $100 they can issue a 2-for-1 split, and now you’ll have 2 shares worth $50 each for every one you had before. Your total dollar investment in the company doesn’t change, though.
As for value, that’s a somewhat more complicated issue to address, but the concept of value in the world of equities is not very different from the way you’re used to thinking of it. It comes down to whether you’re paying a reasonable price for the thing you’re buying. Let’s take a pair of shoes, for example. A well-made pair of shoes will cost more than a cheaply made pair. Between two similarly well-made pairs, though, one may cost more than the other due to some kind of intangible, like a brand name. You can pay up for the brand name, or you can buy the other pair because you recognize it’s a good value for the quality. They’re still more expensive than the cheap pair, but thanks to superior materials and workmanship they should hold up longer and are the better investment despite their higher price. See where I’m going with this? Stock price by itself tells you nothing about the underlying investment, and it’s not the stick by which value is measured.
So how is value measured? That, my friend, is a topic for another time. Right now it’s a beautiful Friday afternoon in October, and my mind is already gone. Maybe my body will join it for a pizza.
Sarah DerGarabedian, CFA
Director of Research