What Does a Low Stock Price Mean?    Bookmark and Share

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When many people begin investing in stocks, they don't have a lot of money to invest. Therefore, they tend to gravitate toward stocks with a low share price. After all, doesn't it sound more appealing to be able to to buy 10 shares of a $10 stock than 1 share of a $100 stock? But this type of thinking can lead to bad investment decisions. Here's why.

Let's imagine that two people, Jane and Joe, are both selling their cars. Both cars are the same make, model, and year and were purchased new five years ago at the same dealership.

Jane has taken great care of her car. She kept it parked in her garage when she wasn't using it, changed the oil every three months, and washed it often. She drove only a short distance to work every day, and had never been in an accident.

Joe's car, on the other hand, is a different story. He used the car to deliver pizzas and in the process racked up a lot of miles. He's been involved in a few accidents, and the car has accumulated a number of visible dings and scratches. On top of that, he has only changed his oil once since he bought the car five years ago and hasn't kept up with the recommended maintenance.

Now, let's imagine you have to choose between the two cars. Which car would you buy? No brainer, right? If you're like most people you would buy Jane's car. It has less miles and is in better shape. If you are like me, you would probably even be willing to pay more for Jane's car than Joe's because you deduce that it is more likely, given its history, to be reliable and to function for a longer period of time than Joe's car.

The same basic pricing principle holds true for stocks. Usually, there is a reason why a $10 stock costs $10 and not $100. The stock market is fairly efficient and usually prices stocks close to their true value.

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Understanding How a Stock Is Valued by the Market
To gain a better understanding of how stocks are priced by the market, let's first briefly look at how stock is issued. When a company first makes the decision to become a publicly traded corporation, it then takes steps to issue stock shares. This initial stock sale is commonly referred to as the IPO, or initial public offering.

Once the initial shares are sold, they are then available to the general public to be traded. Depending on the circumstances, the stock might be initially sold somewhere between $10 to $20 per share. As time goes by, the price of the stock will go up or down for a number of reasons.

Most people would agree that the basic driver of stock price is company performance. If the company does well and its profits increase year after year, the stock's price will generally go up over time. On the other hand, if the company doesn't fare well and its profits remain stagnant or decrease, the price of the stock will likely go down as well.

Because of this, stocks with a lower share price are typically riskier than stocks with higher-priced shares. Since the likely reason the company's stock price is so low is that it hasn't performed well, when you buy a low priced stock, you are essentially betting that it is going to change its course and start to perform well.

For this reason, larger companies with a consistent history of profitability are seen as less risky and are therefore usually priced higher per share than their lower-priced counterparts.

For example, Berkshire Hathaway's A shares are currently trading above $100,000 per share. While this is an extreme example and most investors probably can't afford to buy even a single share of Berkshire's stock, it helps to illustrate the point. Berkshire Hathaway is actually run by billionaire investor Warren Buffett who has managed the company extremely well over time. As profits have increased over time, the share price of Berkshire Hathaway's stock has followed suit.

Stock Splits
Although a high share price is often a sign of past profitability, it is not necessarily a good idea to only look for stocks with high share prices. The reason is that if a stock splits, its price per share will almost always decrease following the split. For example, as a result of its recent acquisition of Burlington Northern Santa Fe railroad, Berkshire Hathaway announced that its B shares would be split 50 to 1. This means that each 1 share of stock that was previously priced at over $3,000 per share will be split into 50 pieces, and will consequently be worth around $60 per share. In this case, due to the stock split, the lower share price will not reflect the company's past performance.

So before you buy a stock, make sure to not only look at the current share price, but also research its history of stock splits. This will give you a better idea of the company's performance over time.

In Conclusion
Let's recap. We've established that it's not necessarily a good idea to hastily buy a stock only because it has a low share price. Doing some research and understanding the past performance of the company as reflected in its share price can help to provide some insight into how well a company has been run over time and if it is likely to be a good investment.

But how can you determine if you're paying the right price for a stock?

  1. First, make sure that you're not overpaying for stock trades. The price you pay for trades is important and adds up over the long run. One of our partners, TradeKing, offers both low cost trades and quality customer service. today to take advantage of their low per trade costs award winning tools and customer service.

  2. You also need to be able to objectively analyze the company's financials. We have developed a free and easy-to-use stock analysis spreadsheet to help you with this.

  3. Another great way to improve your investing ability is by taking the time and learn more about how to value a stock. There are many good books, like those listed below, that can help you learn the basic concepts.

  4. The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel is considered by many to be the original book on value investing. It was written by Benjamin Graham, who is considered to be the father of value investing. It outlines how to analyze a stock and the company behind the stock to determine if it is likely to be a good investment. Warren Buffett claims that this book is "the best book about investing ever written".

    SENSIBLE STOCK INVESTING: How to Pick, Value, and Manage Stocks This book is written by David Van Knapp, and is a fantastic book that beginners can read to learn how to invest. The book covers all aspects of investing, and assumes no prior knowledge of investing. On top of all this, it is a very easy read (which is an extremely rare feature in books covering the topic of investing).

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