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Should you buy shares at a price of $1 or $0.10? Ostensibly, the cheaper share price is more appealing. However, what if there were only 10 shares issued at $1 each compared to 100 shares issued at $0.10 each?
Take it one step further, how do you decide how many shares to buy or how much money to invest if you don’t consider the total value of the company, or the potential future value of the company? Can the current share price alone tell us anything meaningful?
Beginner investors can often find themselves placing more emphasis on share price than other potentially more important considerations such as the total company valuation and the potential for growth. Read this blog as we break down what share prices and company valuation metrics are and how they should impact your investment decisions.
What are Share Prices?
Share prices are the current price at which a single share of a company’s stock is traded on the market. It represents the market value of ownership of a small percentage of a particular company at a given point in time. In a publicly traded company, ownership is divided into shares that can be bought and sold on a stock exchange. The price at which investors are willing to buy or sell the shares on the stock exchange sets the share price.
Each company may determine the number of shares issued at their discretion. This means a single company share may represent a different proportion of ownership for different companies. Let’s go back to the example at the beginning of this blog. A company that issues 10 shares equates to a 10% ownership for a single share. Conversely, a company issuing 100 shares would only represent 1% ownership for a single share.
The Volatility of Share Prices
Changes in the price of a shares are influenced by various factors, including the company's financial performance, economic conditions, industry trends, investor sentiment, and overall market conditions and are usually subject to short-term fluctuations. At Catalist, these short-term fluctuations are greatly reduced due to the periodic nature of trading on our platform, but otherwise the same concepts apply.
Whilst changes in share price do reflect that changing total value of the company, relying on the specific value per share is meaningless without knowing what proportion of the company each share represents. This means knowing a company’s total value can provide a more useful impression of the investment opportunity.
What is a Company’s Valuation?
A company valuation can be a comprehensive assessment of a business’s overall economic value. When an analyst values a company, they often undertake a thorough analysis of various financial metrics, market conditions and future cash flow projections. There are a multitude of methods a company can be valued, although the most common for investors in publicly listed companies is market capitalisation.
Market capitalisation is simply the number of shares issued by the company multiplied by the price per share. Applying this to our example, the company with 10 shares priced at $1 each has a market capitalisation of $10, while a company with 100 shares priced at $0.10 each has exactly the same market capitalisation.
On a traditional stock exchange, market capitalisation is just as variable as share price. In the short term it is driven by supply and demand, which is highly influenced by sentiment. In the longer term though, market capitalisation (and therefore share price) should reflect the economic value the company is able to produce. Successful companies are more valuable, and over time this is reflected in the market capitalisation and the share price.
So why look at Company Valuation Metrics over Share Price?
While share prices and market capitalisation provide a snapshot of a company’s value in the market at a given moment, in the short-term they are not necessarily linked to a more comprehensive and in-depth analysis of a business’s overall worth. One of the key benefits to placing more emphasis on a company’s potential future valuation is that it prioritises the long-term perspective of a company’s value.
Long-term Perspective
Share prices on traditional stock exchanges are highly susceptible to short-term market fluctuations, investor sentiment, and external factors.
Contrastingly, using company valuation metrics such as discounted cash flow, enterprise value, EBITDA (a measure of company earnings) and more provide a better insight of a company’s fundamentals, growth potential and financial health over the long term.
Over time, these long-term fundamentals tend to outweigh short-term considerations. This means that those investors who are focused on long-term goals are better served by considering the potential value of the business and valuation metrics other than just the market capitalisation or share price.
This is especially important in cyclical industries or during economic downturns, share prices may be more volatile and less reflective of a company's long-term prospects. Valuation methods, especially those like discounted cash flow, consider future cash flows, which can provide a more stable assessment of a company's value in uncertain economic conditions. Such information may be provided in regular reporting by many companies.
Conclusion
While share prices serve as a key indicator in the daily workings of the stock market, prioritising other methods of assessing a company’s value offers a more comprehensive and strategic approach to investment decision-making. By considering a company's intrinsic value, growth potential, and risk factors, investors can make more informed and prudent decisions that align with their long-term objectives.
By Joshua Pan
