A common misconception by new investors in the stock market is that the share price of a company is somehow related to the valuation of the company. In reality and in isolation, a single share price tells you nothing about a company's valuation. That is highlighted in the image above where Diageo (LSE:DGE) has a far higher share price than Lloyds Banking Group (LSE:LLOY), yet has a significantly smaller market capitalisation. The market capitalisation of a company is its market valuation. This tutorial will explain a few core concepts relating to this misconception.
A Visual Problem: Amara Mining (LSE:AMA)
The best way to see this misconception is in the graph above. The graph shows the share price action of a small mining company between late 2010 and 04/06/15. Why can a graph be misleading if you're thinking about valuations? Well, the share price in late December 2010 was 105p. The share price today is just 14.75p. That is a share price decline of approximately 86%. Note that this does not mean that Amara Mining's valuation has dropped by 86%.
The reason why it does not have any useful valuation inference is because of the simple point I explained earlier. A share price is just a number and has no direct read-through to a company's valuation. It's the market capitalisation that is important and Market Cap = Share Price x Shares in Issue. In other words, the value of a company is the value of one share multiplied by the number of shares. Therefore, a market cap can increase by one of two ways; the share price increases or the number of shares in issue increases.
The table below outlines precisely why the graph above is misleading if you're trying to infer a valuation change.
We can immediately see that, although the share price tumbled by ~86% between December 2010 and June 2015, the market capitalisation only decreased by around 55%, which is less than 86%. That is simply because of the rapid increase in the number of shares in issue and that has come from placings and equity dilutions. To express this in a different way, by looking at the share price alone, you may conclude that the shares are valued 86% 'lower' whereas in reality the valuation is only 55% 'lower'.
How to Define Price Targets
This last point of the previous section is incredibly important as it could lead you to make some ridiculous statements. If you fail to understand that it's a market cap that outlines a valuation rather than the share price then you're likely to make unachievable price targets.
Consider this; the share price is currently 14.75p. You think to yourself "This has traded at 100p+ before! It must be cheap now that it has fallen so much. It has reached 100p+ before so I am going to set a price target of 100p as I think it can get back to its previous highs."
Unfortunately, this is completely flawed. In fact, if you perform some simple maths, then you can calculate the market capitalisation that has to be reached for the share price to re-hit 105p. You simply take the current number of shares in issue and multiply by 105p or £1.05 so 420,386,077 x 1.05 = £441.4m. That is more than 3x higher than the market cap reached the last time it reached 105p and therein lies the problem. Looking at what share prices were previously traded at is categorically not a credible way of valuing a company.
Instead, you should seek to reverse engineer a price target from a market capitalisation. So don't say you think the share price should be 100p, rather use comparable companies or valuation metrics to find a fair market capitalisation valuation. Suppose you find that a fair valuation for Amara Mining is £100m. You can find a pure price target by dividing £100m by the number of shares in issue to get 23.79p. You can then refine this price target using technical analysis and may choose to pick 23.5p if there is a resistance level at 23.5p.
Some Small Caps Intentionally Choose Low Share Prices...
The reality is that companies with low share prices are still considered as 'cheaper', even if based on a misconception. Indeed, momentum traders often focus on the smallest companies with low market capitalisations as they are easiest to see a share price increase, even if the news does not necessarily justify the rise. That's combined with these companies being not widely held, hence any significant move of shareholders into the company can greatly increase the share price.
Many companies looking to list on the stock exchanges recognise this and seek to price their shares towards the penny range to take advantage of retail investor speculation. They do this almost in a manipulative way (but not quite) as they understand that if they do and the company has decent assets, then there is potential for the share price to trade at premium levels to what the assets are perhaps worth, if momentum kicks in.
This whole point revolves around investor psychology and that tenuous yet real link that many market participants make between a low share price and the 'cheapness' of a company. The phenomenon to price shares towards the penny range is prevalent across the small cap market. In fact, I conducted a scan of a 30 month range of new IPOs for companies with market capitalisations under £50m before funds raised. Figures found are shown below.
Consequently, although there is no way of seeing a company's valuation through one share price, investor psychology still exists such that 'penny shares' (usually companies with share prices under 20p) are treated differently among the retail investor/trader community, sometimes for better, sometimes for worse.