This Stock Is Cheap -- Or Is It?

Genentech (NYSE:DNA) is one of the truly remarkable success stories of the past quarter-century. Nearly a decade after its IPO, Genentech was still a small company that had not yet scratched the surface of its potential. On Jan. 2, 1990, Genentech traded for $2.73. It now trades for more than $77.

That nearly 2,700% gain illustrates the profit potential of investing in promising small companies. It also goes to show that if you want Genentech-like gains, you need to look for stocks trading around $2 per share -- or definitely below $5. Just take a look at this list of winners since 1990 and their stock price back then.

Say it with us: No, no, no!
Here's where we pull back the curtain: All of those Jan. 2, 1990, prices are adjusted for stock splits and -- in some cases -- dividends. While Genentech was a small company back in 1990, it still traded for $21 per share. Intel traded for $36, Applied Materials for $29, Centex for $32, and Linear Technology for $9.50.

So we hope we've done a little bit of myth-busting here. Namely:

1. Lower-priced stocks do not go up any faster than higher-priced stocks.
2. Lower-priced stocks are not necessarily cheaper than higher-priced stocks.
3. Lower-priced stocks are not necessarily smaller than higher-priced stocks.

By itself, a stock's price cannot tell you anything about the value of the underlying company or its investment potential.

That's why Middleby, a stock that's returned more than 600% for subscribers to our Motley Fool Hidden Gems small-cap service, can remain a promising $1.2 billion small cap even though it trades for north of $70 per share. It's also why Ford (NYSE:F) can continue to look like a $17 billion money pit even as it trades for $8.

OK, "money pit" was a bit harsh
Myths about the meaning of stock prices abound, and catering to those myths may be one of the reasons Middleby recently split the company's shares. We'd previously encouraged Middleby's leaders to stop worrying about the stock price, save the time and money required to file the necessary stock-splitting paperwork, and instead continue to focus on allocating capital efficiently and growing the business for the long term.

That's what shareholders should care about. If the business is succeeding, the stock will follow -- regardless of whether it's starting from $5, $50, or $500.

The Foolish bottom line
We readily admit that small companies, as measured by market caps of $2 billion or less, are for many reasons likely to offer better returns than large companies going forward. So if you're looking for stocks with the most potential for outsized returns, start with small caps -- you'll find that a more productive starting point than "low-priced stocks."

Also look for key traits of the market's biggest successes:

1. Cheap valuations relative to a company's earnings or cash flows.
2. Tenured managers who own a significant number of shares.
3. Growing operations in a profitable niche.

And if you can find a company that meets these criteria, it's worthy of your research no matter the stock price. After all, this simple framework is often how we start our research at Motley Fool Hidden Gems. It helped us find Middleby and 50 more recommendations that are beating the market by 34 percentage points on average.

If you'd like to take a look at the stocks we're recommending today, click here to try Hidden Gems free for 30 days. There is no obligation to subscribe, and you might just find a bargain trading for $50 per share.

This article was originally published on Feb. 13, 2007. It has been updated.

Tim Hanson does not own shares of any company mentioned; Brian Richards doesn't own any either. Intel is an Inside Value recommendation. The Fool's disclosure policy would like to remind you that when in Rome, price is what you pay.