Q: How can a lower-priced stock be called more expensive than a higher-priced stock?
- T.K., Champaign, Ill.
A: It's because a stock's price alone is close to meaningless. To draw useful conclusions, you need to compare it with something else, such as sales, earnings, cash flow, etc.
Imagine shares of two companies called Fred and Ethel, each trading for $20 per share. If Fred's earnings per share (EPS) for the last 12 months are $1 and Ethel's are $2, then Fred's price-to-earnings ratio (or P/E, representing price divided by EPS) is 20, while Ethel's is 10. You would have to pay $20 for each dollar of Fred's earnings versus just $10 for Ethel. Aha - already, one company looks cheaper (Ethel).
Consider market capitalization, too, which is the current share price multiplied by the number of shares outstanding. It represents the current total price tag the market is placing on a company. If Fred sports 50 million shares and Ethel has 3 billion, then Fred's market cap is $1 billion and Ethel's is $60 billion. Suddenly it's clear that Ethel is being valued much higher than Fred.
Examine many numbers when studying a stock. For example, look at debt and cash levels, growth rates of sales and earnings, trends in profit margins and return on equity, and a firm's competitive position.
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