Let’s pretend for a minute that I have two things for sale: Item #1 costs $1,000 while Item #2 costs $100,000. Which would you say is cheaper? Instinctively, you might think that the $1,000 item was cheaper because it had a lower price.
But what if I then provided you with more information and revealed that item #1 was a really, really nice piece of chocolate, and that item #2 was a 2,500 square foot house in the Chapel Hill school district. Item #1 might still be cheaper in terms of absolute price. But would you buy it? Or would you rush out and try to pay $100,000 for something probably worth 3 times its selling price?
This oversimplified example gets at the critical distinction between price and value. While price can be a really good piece of information, it doesn’t exist in a vacuum. The chocolate is “cheaper” than the house, but the house is probably a much greater value.
I was thinking about this concept in light of the Apple 7-1 stock split that took place on June 9th. In a 7-1 stock split, each shareholder receives 6 additional shares for each share they already own. To account for the dramatic increase in shares, the price needs to change. Accordingly, the price of Apple dropped from $645.57/share on Friday, June 6th (when there were just 861 million outstanding shares) to about $93/share on Monday, June 9th, when the number of outstanding shares exploded to 6 billion.
The morning of the actual split, at least one news show noted that some experts considered Apple’s stock to be cheap after the split. But why? Nothing material changed about Apple over the weekend! All that changed was the sticker price.
Simply comparing the prices of stocks relative to each other – or in the case of Apple, to itself pre/post-split – is comparing apples and oranges. (I’m sorry; I had to.) That’s no way to tell what’s “cheap” and what’s “expensive.” Instead, it’s more appropriate to scale price by some common element so that prices are relative to each other, similar to how house prices are sometimes expressed in dollars per square foot.
There are a number of ways to scale stocks to transform price into relative price. One popular method is to scale prices by a company’s earnings, known as the P/E ratio (P = Price; E = Earnings). Another common method is to scale stock prices by the book value per share of a company, where book value can be thought of as the sum total of all of the assets of a company. As it turns out, stocks with a low price-to-book value (“value stocks”) tend to outperform stocks with a high price-to-book value (“growth stocks”) over the long term.[i]
Either way, Apple’s book value and earnings didn’t change over the weekend. So the stock wasn’t any more or less expensive on Monday, despite a share price drop of over $550/share. While Woodward Financial Advisors doesn’t perform individual stock analysis, we do think it’s important to know the critical difference between price and value.
[i] Research from Dimensional Fund Advisors suggests that from 1927 – 2013, the long-term value premium has been about 4.99% per year, though that doesn’t mean that value stocks outperform growth stocks every year. There are a number of years, or even 5-year periods, where value stocks underperform growth stocks. In fact, since 2007, growth stocks have actually outperformed value stocks in 4 of the last 6 years. But that followed a 7-year period when value stocks handily outperformed growth stocks every year.