Aug 21, 2011

The Pricing of Shares

Most people tend to think that a share quoting at Rs 1000/- is more expensive than a share quoting at Rs 10/-. I’ve seen many people looking to invest only in shares quoting at very low prices (what in the trade are known as ‘penny stocks’) believing them to be cheap. While this is true speaking in ‘per share’ terms, it’s not correct to go about valuing shares as such. In this post I will proceed to explain why.

If you own a share certificate- it implies that you own a part of the underlying company. So assume we have 2 companies A & B both valued at 10 lacs each. Both decide to go for an Initial Public Offer (IPO). ‘A’ decides to price its shares aggressively and quotes its share at Rs 1000/-. That means you will have 1000 shares of company A (10,00,000/1000) in total. B decides that it wants to price its shares at Rs 10/-. So you will have 1,00,000 (10,00,000/10) shares of B in total. In both the cases the total valuation of the companies remains the same, i.e. 10 lacs.

I’ll explain this with an example. Suppose you own a fairly large plot of land and decide that you want it sell it off in small equal plots. Now the size of the small plots is completely up to you. You can sell it in square feet, cents, grounds, acres, bighas- whatever, in any measure you want. The choice is completely yours as it’s your property. It’s a similar thing with shares. A business is free to price its shares initially in whichever way it wants. Understanding this is very important. 

Now suppose I’d invested 1 lac in both companies A & B. For A I’ll get 100 shares and for B I’ll get 10,000 shares. Suppose both companies are doing well and the valuation of the companies goes up to 12 lacs each. Then my initial 1 lac investment becomes 1.2 lacs in both cases. In per share terms - A’s price would have moved up from Rs 1000/- to Rs 1200/-, whereas B’s price would have moved up from Rs 10/- to Rs 12/-. In both cases my return on investment is the same.

Savvy investors should focus more on the return of a share than its price.  In the above example, if after your analysis you feel company A is a better prospect than B then you should buy A’s shares. The only advantage with shares quoting at relatively lower prices is that you can allocate small amounts of capital more effectively, i.e. if you have only 1000 bucks to invest then you could buy 50 shares of B and use the remaining 500 to invest elsewhere and diversify

Thinking that having more quantity of shares makes you a better investor is foolish. Quantity is immaterial- it’s quality that matters. As an investor, your focus should always be on return.

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