If you’ve just begun learning about the stock market, you probably have noticed that some stocks trade at much higher prices than others. It can be intriguing to observe that penny stocks are only priced at a few cents, while major companies such as Amazon (AMZN) trade at more than $3000 per share.
In fact, the most expensive stock on the stock market by far is Berkshire Hathaway Inc. (BRK-A), which is currently trading at a staggering $340,000 per share.
But why is the range of existing stock prices so wide, and does this mean that expensive stocks are more valuable than “cheap” stocks?
The short answer is that high priced stocks are so expensive because of the number of existing shares within the business being low relative to the company’s total market capitalization. The higher the number of outstanding shares a company has, the lower the price of each share is going to be.
Please note that stock prices on their own don’t tell you anything about the value and quality of the underlying business. Therefore, comparing stock prices of different companies with each other is meaningless.
Berkshire Hathaway’s value has been growing steadily for several decades but because the company has never gone through any stock split in its history, its stock price is now the highest in the world.
But in order to understand why some shares are priced much higher than others, we need to clear up what actually makes up the stock price of a company.
What Makes up Stock Prices?
The price of a stock can be calculated by dividing the market capitalization (which is the total value of the company defined by the stock market) by the total number of outstanding shares.
Both the market capitalization and the number of shares can change throughout time, which would then result in a change in the company’s stock price.
Stock prices tend to rise along with the growth of the company. This only makes sense, as investor’s valuations of a company tend to increase in the long run with the company’s rising value.
The number of existing shares is completely up to the business to decide. A start-up might consist of only ten shares, while big publicly trading companies will have at least millions of shares outstanding.
This is why stock prices of different companies can heavily vary from each other. A business that has a market capitalization of $10.000 and 100 shares outstanding will have a stock price of $100 per share, whereas another business with the same market capitalization and instead 2000 outstanding shares will trade at only $5 per share. Both companies esssentially have the same market value despite having very different stock prices.
Even if the stock prices of both companies are very different from each other, the total market value of both businesses remains the same.
This is because Facebook’s number of shares outstanding was 2.87 billion, whereas Berkshire Hathaway class A had only 1.635 million shares outstanding.
The Effect of Stock Splits
Within the corporate finance world, many public companies will usually try to keep their share price at a low level by increasing the number of shares with stock splits in order to attract more investors.
When a company conducts a stock split, it divides the existing shares of the business into multiple shares, resulting in an increased number of shares outstanding after the stock split is completed.
As an example, in July 2020, Coca Cola’s (KO) stock price had climbed to more than $80 per share. The company then announced to perform a 2 to 1 stock split, meaning that every investor would now own 2 shares for every share they held. Because the total amount of shares outstanding was now doubled, the stock price went down to roughly $37 per share.
Of course, that didn’t mean that the value of the overall company decreased. After a stock split, the market capitalization remains constant but the number of shares outstanding increases, leading the price of each share to fall, as the company’s value is now apportioned to more existing shares.
Why Companies Split Their Stock
As soon as a company’s stock price rises to excessive-high levels, fewer investors might be able to invest in the company because of the high entry point to acquire shares of the business. Companies try to avoid that by splitting their stock in order to increase their shareholder base.
Since a stock split will effectively reduce the price of each share, a company’s stock trading at a low price might now seem more affordable for even smaller investors, resulting in increased liquidity of the stock.
High stock liquidity can give several benefits both for the company and investors.
With more shares and shareholders trading at the market, buying and selling shares becomes easier without taking a big spread between the bid and ask price. The fact that many people are trading the stock may also be a signal for increased attention and popularity around the company.
Stock splits, in general, are usually a positive sign for most investors, as it shows that the company is steadily growing and its stock price is continually rising. This is why oftentimes the price of each share might even increase due to higher demand shortly after decreasing from a stock split. That could also motivate companies to conduct stock splits whenever it’s appropriate to do so.
Not Every Company Prefers Stock Splits
Above, we mentioned that Berkshire Hathaway is now by far the most expensive stock in the world because the company had never decided to perform a stock split for their Class A shares. This is a great example of why stock splits, in general, are not always necessary for businesses to grow massively.
Berkshire Hathaway belongs to the largest companies in the world and is led by Warren Buffett, who is not only one of the wealthiest people in the world but also arguably the best investor that has ever existed.
The reason why Buffett didn’t decide to split Berkshire’s stock and isn’t likely to do so in the future is that he views his shareholders as business partners and not just regular investors who can get in and out of the company in short periods of time.
He prefers his investors to rather have a long-term focused mindset by making it relatively hard to trade the stock quickly because of the high price point.
In fact, many companies also prefer to not split their stock because of the high price and the perception which comes from that. Stocks that are especially high priced might show some sort of high value, even if stock prices don’t tell anything about the underlying business.
Highly expensive stocks may also attract investors that think differently than most other people and are more serious about the long-term growth of the business.
Either Way, there are definitely some good reasons why companies might want to split their stock but history has shown that it is not necessary for every business to split their stock anymore since stock prices alone only have a perceptible impact on investors.
A higher stock price doesn’t reflect the value of a business but sometimes it might give you a clue about how a company treats its stock.