The value of a stock is not the share price attached to it. A share price is basically the unitary price of a share relative to its value (the numerator) and the number of outstanding shares (denominator) – Let me use an example to throw more light into this. Supposing you have two companies A & B. Company A has a total market capitalisation of N200m and has 2million shares outstanding. Company A therefore has a share price of N100 per every share (N200m/2m shares) . Company B on the other hand has a total market capitalisation of N100,000,000 but has 1million shares outstanding. Thus Company B’s share price per unit is also N100 i.e (N100m/1m shares).
In the example above both companies have the same share price but have different values. Company A is valued at N200m and B N100m. The more shareholders a company has the more likely its price will seem low in comparative terms to its market capitalisation. Drawing from above, it is therefore important for investors not to look at the price of a stock as an indication of its value. In fact, values should be assessed relative to earnings which is why the Price Earnings Ratio is a very popular way of valuing companies.
To put it into better perspective using the example above, assuming Earnings Per Share (EPS) for Company A is N20 per share and that of Company B is N30 per share. On paper it means Company A made N40 million in profits and Company B N30 million. However, Company A is priced at 5x its earnings (N100 share price divided by N20 EPS) and Company B is 3.3x (N100 per share divided by N30 EPS). As such, Company B is actually a cheaper stock. This is what is called your price earnings ratio. I like to even look at this differently… that is in an inverted form.
Company A makes N20/N100 which is a yield of 20% and
Company B N30/N100 which is 30%.
This is what is called the Earnings Yield and as you can see when you invert the formulary it shows the 5x P.E ratio is equivalent to an earnings yield (returns on share value) of 20% and 30% for A and B respectively.
Correction:
An earlier version of this article erroneously stated in paragraph 3 that Company A’s earnings was N20million instead of N40million. It has now been corrected. Thanks to our reader Ola for the correction.