What is a share price?

By now we understand it to represent the expectations of future profits of the company. These expectations help us calculate a valuation for the stock, by means of a metric such a the price earnings ratio.

We know that the Price/Earnings ratio considers the total market capitalisation of the company, its number of shares, the share price and it's expected earnings per share. To get the share price you simply divide the market cap by the number of shares.

A company can choose how many shares it has in itself. Imagine owning your own business. How many shares would you decide to split the ownership into? Do you own it along with a business partner? Are there 10 of you? Think back to our example of the lottery syndicate. The number of players you have investing an equal amount into buying the tickets is the number of "shares" you have to divide the winnings by. So it may depend on how many investors you expect to have, not only for now, but well into the future. If you get to the stage of the company floating on to the stock market, the chances are you will already have divided the company into millions of shares. But, importantly for us here... the number is relatively arbitrary. Your small cake baking business could be divided into 10,000 shares or 10 shares. It's up to you. And the choice made by companies is extremely widespread.

Lets take two similar size American companies as an example. Fund manager Berkshire Hathaway was started by two of the best investors in history, Warren Buffet and the late Charlie Munger. It has a market capitalisation of around $777bln usd. They have decided to split themselves into just over 2 billion shares, leaving a share price of 780/2.2 = $360 usd per share.

Microsoft is a company that we all know well, and is one of the biggest in the world. Its market capital is $2.5 trillion, or three times the size of Berkshire Hathaway. However the share price of $370 is roughly the same. How can a company that is three times bigger than another one have the same share price??

Because there are over 7 billion shares in Microsoft. That is three times as many shares in Microsoft as there are in Berkshire's 2.2 billion. So you have to divide the market cap by a much bigger number to get the share price. In these two examples;

Microsoft: $2.6 trln / 7 bln shares = $370 share price

Berkshire H: $777bln / 2.2 bln shares = $360 share price.

You can see from this example using some of the biggest companies in the world.... the share price is irrelevant! Tomorrow, Berkshire H could announce that the company was going to double the number of shares in itself to 4.4bln, and the share price would half in value to $180 per share (Shareholders wouldn't lose any money as they would receive 2 new shares for every 1 old share they owned!).

Share prices don't matter. So never ever think that you should invest in a stock becasue it's share price looks cheap at $50 or $20 versus other ones in the market at $360. It is possible they simply have much more shares in circulation than the other companies.

To decide whether a stock is cheap or expensive, we need to look at it's earnings expectations and it's valuation!