Stock Trading Myths - Share Price and P/E Ratio

A common misconception among investors and traders is that a stock at $5 per share is “cheaper” than a stock trading at $500 per share. This seems to be common sense, but in reality, it just isn’t true.

Many investors, particularly newcomers to the world of trading, are tempted by the allure of a “cheap” stock trading at under $10, failing to realize that the stock may not be cheap after all.

For many, this lesson is learned the hard way - through the loss of hard-earned money. Here are some simple concepts and examples illustrating what actually makes a stock “cheap.”

Stock Trading Myth #1: All Stocks Are Created Equal

The idea that a stock trading for a triple-digit share price is more expensive than a one trading for less than $10 is one of the most persistent, and yet completely baseless of all trading myths.

On the surface, this stock trading myth makes perfect sense. After all, a bottle of wine that sells for $280 is undoubtedly more expensive than a bottle of the same size that sells for $2. Sure, you would expect the $280 bottle of wine to be of higher quality, but that’s a matter of personal preference, not fact.

The fact of the matter is that the two bottle of wines are equal in terms of size, but not in terms of price - one is expensive and one is cheap.

When it comes to trading, the difference is that not all shares of stock are created equal. They are, in fact, not all the same size. If a company has a total of 1 million shares of stock outstanding, and you own 100,000 shares, you own 10 percent of the company.

If another company has a total of 10 million outstanding shares, and you also own 100,000, you own just 1 percent of the company. Unlike the two 750 ml bottles of wine, these two stocks are not equal in any way.

Stock Trading Myth #2: Sirius Is Cheaper Than XM

Take the example of Sirius (SIRI) and XM Satellite Radio (XMSR). Sirius trades for around $5 per share and XM trades at $15. On the surface, it would seem as though XM were three times as expensive as Sirius, but upon closer inspection, Sirius is clearly the more expensive of the two.

This is because XM has around 258 million total shares outstanding, whereas Sirius has 1.4 billion. If you owned 10 million shares of XM, you’d own approximately 4 percent of the company, whereas if you owned 10 million shares of Sirius, you’d own less than 1 percent of the total shares.

Neither Sirius nor XM have made positive earnings (profits) as of yet. Sirius had annual sales of $325 million in 2005, whereas XM had sales of $663 million.

Per share, this equals sales of about $0.24 per share of Sirius. XM had sales per share of $2.88. Since the share price of Sirius is about 1/3 that of XM, it would be fair to multiply Sirius’s results by three.

Even making this adjustment, $15 of Sirius stock earned sales of just $0.72 in 2005, whereas $15 of XM stock earned $2.88. XM is, by all reasonable measures, much cheaper than Sirius.

Do you see the insanity of thinking that Sirius is cheaper just because its share price is lower? A stock trading at a low share price is not necessarily cheap. A stock at a high share price is not necessarily expensive.

The above example used sales data because neither company has turned a profit as of yet. Normally, earnings (profits) data would be used to determine the stock’s P/E (price-to-earnings) ratio.

Conventional wisdom says that a stock at a lower P/E ratio is cheaper than a stock trading at a high P/E ratio, and in this rare case, conventional wisdom is correct. But anyone who says that a stock at a lower P/E is a better value than a stock trading at a higher P/E takes the conventional wisdom too far.

Just think of the wine example: Some $2 wine might be as good as some $10 wine. In this case, the $2 bottle is a bargain. But some, if not most, $2 wine is cheap for a reason. The same is true for a stock at a low P/E ratio.

Stock Trading Myth #3: Low P/E is Good; High P/E is Bad

The key to making money on a stock is to find a stock at a value. Mere share price is not enough information. P/E ratio, income statement and balance sheet data, and technical chart patterns are the tools of true stock trading pros.

First and foremost, though, novices must overcome popular trading myths that only inhibit stock trading success.

William Smith the author provides additional financial information on many subjects as well as the secret to his success in the market along with 5 Free power stock picks emailed daily so grab your Free subscription on his website at http://www.sexsitemint.com/free_stock_picks.shtml (All is Free)