Stock Learning

To better understand what the share price is let's take an example of 2 well known companies: IBM and ORACLE.

On July 16th IBM (NYSE:IBM) closed at $125.94 a share and ORACLE (Nasdaq:ORCL) closed at $20.44 Which company is cheaper?

The beginner, of course, would say - ORACLE - because it's $105.50 less than IBM. The truth is that their share prices are almost the same, actually IBM is even a little cheaper. But you have to understand their price-to-earnings ratios to see through the $125.94 to $20.44 disparity. You have to understand the ratio to know that $125.94 isn't more expensive than $20.44

You see, we don't care about the actual price that we pay per share. If IBM, for example, were to announce a 6-to-1 stock split tomorrow, you would be paying $20.99 a share, and instead of saying that IBM is selling for $102.95 more than ORACLE, you could say it is selling just for $0.55 more. So share prices are just guideposts that a company can change at will. They don't help you to figure out relative worth at all.

What really matters isn't the price that you pay for the share but price-to-earnings ratio of each stock. You have to take share price and divide it by the amount per share the company earned in the previous year - EPS.

ORACLE earned $1.06 last year. That's the number that can be found by simply inputting ORCL, ORACLE symbol, into stock quote on the front page. This will instantly tell you how much money, on a share basis, ORACLE made.

Now, you divide $20.44 - the last price paid - by $1.06, and you get 19 (rounded to the nearest whole number). That's the number that you need to know, ORACLE trades at 19 times earnings. You are paying 19 times ORACLE's previous earnings per share for each share that you buy. That's the real price. The (M)ultiple, 19, times $1.06, the (E)arnings per share, equals the (P)rice per share. Price is expressed as an equation: M x E = P.

IBM, on the other hand, earned about $7.67 last year and it trades for $125.94. What does it trade at times earnings? Divide the $125.94 by $7.67 and you get roughly 16 (again round it because the precise multiple isn't as important as the approximation). So IBM trades at multiple of 16 times earnings. Now we have something that allows us to compare the two companies; we have something that explains the relative worth of each company's shares. ORACLE trades at 19 times earnings while IBM trades at 16 times earnings.

While IBM at $125.94 seems over $100 more expensive that ORACLE at $20.44, when we make the comparison by breaking it down by P/E (price-to-earnings) ratio, we see that ORACLE at $20.44 is actually more expensive than IBM at $125.94. Almost 20% more expensive, despite the price quoted.