One fine day, a mother is preparing for her Thanksgiving dinner for her husband and children. She goes into the supermarket and walks up to the poultry section pondering how big of a turkey she should buy. She knows she wants 10 pounds, but doesn’t know if they’ll have that large of a turkey. As she approaches the turkeys, she ponders, “Oh, what am I going to do if they are all out of big turkeys?” When she gets there, sure enough, they are all out of 10-pound turkeys, so she decides to buy two 5-pound turkeys instead.
With the exception of a little more cleaning of the turkeys, does it really matter if she buys one large turkey or two medium size ones?
Bar none, the price of the stock is by far the most common misconception I have heard from inexperienced investors who are considering buying a stock.
The conversation invariably goes something like this,
Me: “Take a look at Apple — they are really growing their earnings, etc. etc.”
Investor: “Hmm, what’s the stock price now?”
Me: “$250”
Investor: “Hmm, that seems very expensive to me.”
Me: “It really makes no difference what the actual stock price is. You have to look at how that price compares to their earnings, and how fast they’re growing their earnings.”
Investor: “What do you mean?”
Me: “Well, does it matter if you buy 1 share of apple for $250 or 2 shares of another stock selling for $125? Or think of it another way. Does it matter if you buy 1 10-pound turkey or 2 5-pound turkeys if the price per pound is the same?”
Investor: Silence.
What’s not to understand about a seemingly simple concept? Many very smart people who I’ve explained this to repeatedly, who are inexperienced investors, seemingly have the most difficult time understanding this. or practicing their understanding of this. I’ve concluded over the years, that they understand it, but just have a difficulty putting that understanding into practice.
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StockA=$125 StockB=$250
2 shares of StockA = 1 share of StockB — > $250=$250
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1 10 lb turkey = $50 1 5lb turkey = $25
1 10lb turkey = 2 5lb turkeys — > $50=$50
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Here’s the thing about trading or investing — even if you understand that something makes sense, when it comes to giving up your money for the possibility of either making more money or losing that money, investors don’t always act rationally. So, even though this is a very simple concept, when it comes time to write the check, or buy the stock, investors may be irrational.
This happens even with experienced investors in other parts of the market. Even when I’m trading options, or talking with another very experienced trader or investor while we are both trading in real time, I may hear myself say, or see my self message him something that goes like this, “I’m such an idiot — why didn’t I sell it when it broke below 110 — I had just told you support was at 111 and I was gonna sell.” And the experienced investor friend knowing exactly that I’m not an idiot — I’m just an experienced investor who happens to be human, with real emotions, fears and greed, all of which get in the way of making consistent rational decisions.
I am close friends with one of the smartest people I know who has 30 years experience trading options and investing in stocks. He will rationalize, as all of us can do, about why he made a decision regarding buying a stock that’s been out of favor for years — and I’m certain we both know that it’s a bad decision, yet, he does it anyway. Human — irrational.
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I think it just feels better to own more shares. But, this is a very flawed reason for choosing a stock as I explained above. This is why many investors are attracted to lower, priced, stocks. I have heard this conversation before also more than a few times,
Investor: “I bought XYZ stock. I own 100,000 shares!”
Me: “What price is it trading at now?”
Investor: “11 cents per share. If it just goes to $2, that will be like a 2000% return!!”
That’s true. However, there are so many more important determining metrics to consider before investing in the company besides a speculative future price based upon no information at all, or how many shares am I able to own.
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Let’s consider Amazon, AMZN. As of today, the stock is at $2,400 per share! Wowwee !! That’s a big number!
Let’s also consider Zoom, ZM. As of today, the stock is at $160.
(Full disclosure: My portfolios own both AMZN and ZM).
Just because AMZN is almost 20x the price of ZM, that does not mean Amazon is more expensive!
In fact, ZM is much more expensive when looking at the Price/Earnings, P/E ratio.
Stock Stock Price EPS Valuation (P/E)
AMZN 2400 $23 104
ZM 160 35c 457
Consider that I have $20,000 to invest. Does it make any difference which stock I buy based upon the stock price? No.
If I buy AMZN, I can buy $20k/2400 or 8 shares.
If I buy ZM, I can buy $20k/160 or 125 shares.
It seems sexier, more fun, richer, more impressive — MORE SHARES — pick your jargon — to own 125 shares, rather than just 8. But there’s really no difference, they both equal $20,000.
If AMZN increases by 100%, you still only own 8 shares at a price of $4800. Your $20k grew to $40k. If ZM increases by 100%, you still own 125 shares at a price of 320. Your $20k grew to $40k.
Don’t consider the stock price, AT ALL, when deciding if you should buy the stock.
Much more important is to consider the quarterly and annual growth rates and how those growth rates compare to the P/E ratio. You can read this post for more information about that.
So the next time you pull up a quote on a high priced stock, before reacting to that price irrationally, take an extra moment to think if it matters if you buy two 5-lb turkeys or one 10-lb turkey.
Gobble! Gobble!
