Finance 101: Why A Stock’s Price Doesn’t Matter

By: ispeculatornew
Date posted: 02.29.2012 (5:00 am) | Write a Comment  (2 Comments)

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Last weekend, I spent a decent amount of time discussing the upcoming Facebook IPO, which seems to be on everyone’s mind these days. Everyone has their own opinion about it, which is certainly a great thing. Many think that Facebook is the biggest sign of a bubble while others such as myself think it’s a great bargain . Obviously, the types of discussions that I have when discussing with some friends and co-workers that work in the financial industry are incredibly different from those I can have with friends or family that is farther away.

One discussion that I had regarding Facebook with a few people was regarding the stock’s price when it would IPO. More specifically, I had comments like this:

“Would you buy Facebook if the stock’s price is at $100? Or what price would you be willing to pay?

At first, I thought it might simply be a communications issue so I would answer something like:

“I don’t really care about the price, I do think that at a $100B valuation, it is still a good deal”

I would then get some confused looks and answers regarding how:

“Apple (AAPL) and Google (GOOG) actually deserved their high prices considering all of that success but that there were too many questions regarding Facebook.”

Clearly, I think that these prices cause some confusion so today I thought I would write about this. Let’s use a simple example with smaller numbers. Let me know if you think this all makes sense.

Imagine a company named Facebook that is looking to start sellings its shares. For this example, let’s imagine that it will sell all shares of the company, which it expects to be worth $1000.

Facebook currently makes:

-Annual revenues $38
-Annual profits: $17

Is the price of $1000 too high? Let’s forget about that question for now and simply focus on this. Facebook is hesitating between two structures:

Sell 10 shares
Sell 100 shares

If it decides to sell 10 shares, those will be sold for $100 and each share is basically accumulating $3.80 of revenues and $1.70 of profits.
If it decides to sell 100 shares, those will be sold for $10 and each share is basically accumulating $0.38 of revenues and $0.17 of profits.

As an investor, let’s imagine that I have decided to buy Facebook shares and have $100 to invest. Which do I prefer? Buying 10 shares at $10 each or buying 1 share for $100? It comes out to the same thing!! In both cases, I will be owner of 10% of the company and thus have “rights” to 10% of the profits.

So do I have any preference between a $100 or a $10 price? No, not at all.

Back to my example. When I say that I don’t care about the share price but about the valuation. What I mean is that:

-I do not care if I get 10 shares at $10 each or 1 share at $100 each
-I do however care very much if the company decides to sell its shares at a valuation of $2000. In that case, my $100 would buy me 5% of the company’s profits instead of 10%.

Is this example clear at all? Do you agree?

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