I got hit with a question the other day that spun me out a little.
“What is the share price?”
‘Well…It’s what the market thinks a company’s shares are worth’, I replied. (Technically true, if not very enlightening).
“Yeah but…who decides what they are worth? Is it like…a company’s assets or something?”
‘No, it’s not a company’s assets. It’s a measure of how much cash people think a business is going to earn in the future. Imagine that a car was a business. How much money do people make from driving their car every day, excluding delivery businesses and Uber etc?’
‘Right, but you have all those costs like insurance, petrol, maintenance, etc. So, you lose money by driving your car and never earn a cent – that business is worth about $0. But as a car, as an asset, it’s worth say $20,000. So even if a business has a lot of assets, unless it generates money, it’s not necessarily worth anything – unless it closes down and starts selling assets.’
There are plenty of exceptions – for example, MMA Offshore Ltd (ASX: MRM) shares hold some value, despite being a loss-making business, because of the considerable assets on its balance sheet. Wesfarmers Ltd (ASX: WES), shares held their value quite well despite profit falling by $2 billion last year, which was due to assets being revalued downwards on paper. Or at the other extreme, you have companies like Auscann Group Holdings Ltd (ASX: AC8) with minimal assets and no earnings, which is valued at $50 million because people think it will earn cash in the future.
However, as a general rule, the share price relates to how much cash a business is generating, or how much people think it can generate. So why are Commonwealth Bank of Australia (ASX: CBA) shares priced at $82 and Wesfarmers shares are only $40?
Typically you would think it is because Commonwealth Bank earns more than Wesfarmers does. However, there are several other major things that can affect a share’s price, especially:
- The number of shares on issue (a company’s profit gets divided among a smaller or larger number of shares, affecting the amount that each share earns, and thus the value of each share)
- How much people are willing to pay for each dollar of a company’s earnings (some company’s earnings are more highly valued than others; this is reflected by the P/E multiple)
There are also plenty of other smaller things that can affect the share price, for example if a business is capital intensive, cyclical, a commodity producer, has a lot (or little) debt, faces lots of competition, is likely to grow rapidly, and so on – but that’s a story for another article.
Just know that the share price essentially reflects either how much cash each share earns, or how much cash people think each share will earn. If the share price is an outrageous price for an apparently small amount of earnings per share, try and figure out why.