It's a common mistake among investors: If a stock's price is low, it must be good! By low, I mean a few dollars. Or even $20, when compared with a $50 alternative.
As I type this, Citigroup
Remember, you really need to have two prices in mind when you buy a stock: its current price, and its intrinsic or fair value -- what you think it's really worth. Even if a stock trades at $1 per share, it may well be worth just half that. If so, it's more likely to head south over time than to surge.
Meanwhile, some stocks that sport seemingly steep prices might actually be bargains. Insurance operation Fairfax Financial
But here's perhaps the best example: Warren Buffett's company, Berkshire Hathaway
When looking at a share price, also be sure to consider the company's market capitalization -- the share price multiplied by the number of shares. The market cap tells you the total value that investors are placing on the company right now, and it's much more meaningful than its share price. (If you don’t know how many shares a company has, the price of each is kind of meaningless.) Often, you'll find that companies with higher share prices actually have lower market caps, because they have fewer shares outstanding. So don't get confused!
Don't focus on quantity
In addition, some people get excited about low-priced stocks because they can buy a lot of them with relatively few dollars. If you have $5,000, you can't even afford two class-B shares of Berkshire Hathaway, but you can get more than 1,000 shares of Citigroup. Unsophisticated investors will assume that 1,000 shares are better than one -- but they need to ask themselves which stock is likely to rise more, and how safe or risky each stock is, among other things.
This kind of thinking makes lots of people lose lots of money on penny stocks -- they get excited at the prospect of owning 10,000 shares of a $0.05 stock (for just $500), not realizing that it's more likely to fall to $0.01 than to rise to $3. Remember that if you buy 10 shares of a $500 stock, and 1,000 shares of a $5 stock, and they both go up by 10%, the share price makes no difference: You'll still be up the same $500 on each position.
Another way to end up with 1,000 shares is to buy into a healthy, growing company that splits its shares. (Not all companies split their shares, though -- that's why Berkshire's shares are priced so high.) A two-for-one split will give you twice as many shares as you currently own, at half the price. The net change in their value? Nada. Splits aren't really such a big deal -- unless you like the idea of owning lots of (lower-priced) shares.
But here's another split-related caution: Sometimes a stock you're following can suddenly appear to surge in value, by doing a reverse split. A reverse split leaves you with fewer shares at a higher price. When a company's stock price falls to embarrassing levels, or when it needs to meet listing requirements for the exchange on which it trades, it may do a reverse split. AIG
What to do
So, never put too much stock in a company's share price without getting more context. Focus on the stock's value -- how undervalued you think it might be, and how well it might serve you.
This article was originally published on March 30, 2009. It has been updated by Dan Caplinger, who owns shares of Berkshire Hathaway. The Fool owns shares of Berkshire Hathaway, which is a Motley Fool Inside Value pick and a Motley Fool Stock Advisor selection. The Motley Fool is Fools writing for Fools.