Why share price doesn’t matter

It’s important that you understand why the share price of a company does not matter so you avoid ending up making poor decisions. If we have 2 companies – say company “A” and company “B”.

A makes profits of $100M p.a. and pays half of its profits out as dividends.

B is a smaller company. B competes with A in a similar industry, makes profits of $50M p.a. and also pays out half of the profits as dividends.

For this given industry, the P/E (price-to-earnings ratio) runs at around 10 times so the market capitalisations will be around $1B and $500M respectively.

A has 100 million shares on issue, so the share price would be around $10 each and the dividend would be $0.50 per share – 5% yield.

B has 10 million shares on issue, so the share price would be around $50 each and the dividend would be $2.50 per share – also 5% yield.

Which company is more likely to be able to double its share price?

Both are capable of doing this, but it has absolutely nothing to do with the share price – it is all to do with their profits. 

The share price in isolation tells us nothing about profits or the ability of the company to grow its profits/share price.  Generally speaking, the smaller company B is more likely to be able to double profits (and the share price) because smaller companies are generally more flexible than larger companies, but too many investors would have discounted B because its share price is higher than A. 

This is why P/E ratios and dividend payout ratios and dividend yields are useful – they allow us to make some kind of meaningful comparison without having to do the calculations I have outlined above (albeit I have kept them fairly simple).

A good example of a high-priced share is Berkshire Hathaway listed in the US – on 4 May 2023 it was trading at US$488,600 per share. Imagine if you did not buy it when it was trading at $100 because you thought it could not increase tenfold! 

In the past, Australian companies wouldn’t allow their share prices to increase above $100 – companies would split the shares to reduce the share price.

For example, if you hold one share and a 10 for 1 share split takes place, this increases the number of shares by 10 times, and will result in the share price falling by 90% (the same value is still there – it’s just made up of more shares at a lower share price).

This was done with Incitec Pivot in 2008.  Its share price was around $130 (it had peaked at around $170) and they did a 20 for 1 share split effectively reducing the share price to $6.50 – it was still the same company but it resulted in many investors considering investing in it whereas previously they wouldn’t (because they thought the share price was too high!)

Conversely many smaller companies regularly engage in share consolidations, to improve the perception of the company.

As an example, if we have a company with 800 million shares on issue and the shares are trading at $0.05, the market capitalisation of the company is $40m. If the company does a 800:1 share consolidation, the number of shares reduces to 1 million shares and the share price should increase to $4.00, all else being equal.

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