The notion of using value to determine utility is commonplace for all people as they perform their normal daily activities. “I am not paying $6.00 for a cup of coffee” is actually a value-driven decision as much as it is a price-driven decision. I am sure if you dug deeply you could come up with $6.00 – even in a recession. However, you don’t see $6.00 of value in the coffee. In fact, value is the underlying element to all buy or don’t buy decisions we make. Do we find at least enough value in the product to pry our cash out of our hand for the utility derived from the product?
Value is most easily derived through a relative analysis. You might not see $6.00 of value in a cup of coffee at Starbucks, but then you next door to Caribou and the same cup of coffee is offered for $8.00. Now what? The value calculation in your brain is all out of whack. Through relative analysis, the $6.00 cup of coffee all of a sudden seems like it might be a good deal. You now “value” that cup of coffee at $6.00. Of course, this analysis only works when you are dealing with exactly the same product. Commodities are the perfect example of this. I am generalizing that all cups of coffee are exactly the same or a commodity in the example above – I know there are a lot of connoisseurs out there that will take offense.
Now we come to investing. Many times people will mistakenly value shares of stock based on a crude relative analysis using the prices of all shares in the universe. They assume a share of Borders Group is the same as a share of Apple. Borders Group is now trading at $.37/share and Apple is trading at $351.88/share. New investors will want to quickly discern that Borders Group is cheaper than Apple and conclude it to be a better deal. The conclusion could not be further from the truth. In reality, there are no two companies that are exactly the same. All shares are created differently.
As I write this, Borders Group is most likely preparing to file for Chapter 11 bankruptcy protection and being delisted by the New York Stock Exchange for non-compliance with listing standards. Anyone with a few business classes in college knows that there is a pecking order in a bankruptcy and the common shares are the last on that list. Even if Borders Group continues to operate the business the likelihood of an investor in common shares losing 100% of their investment is near 100%. Will Borders Group still be a good deal when you lose everything in the near future?
Apple is on the other end of the spectrum. They have a great product lineup with innovations unmatched in the industry. Apple has so much cash on their balance sheet that putting all that cash to work is very difficult and problematic – albeit a good problem to have! It is safe to assume that Apple is not going to go bankrupt anytime soon and probably not even in our lifetimes (though stranger things have happened.) There is a high probability that you will not lose all of your investment buying Apple shares. This is not to say that you won’t lose money based on the normal fluctuations in business cycles.
Using a relative analysis can still be used to determine relative worth, but price is only part of the equation – literally. The measure most commonly used to measure stocks is called the P/E ratio. The price per share is divided by the earnings per share yielding some number. The lower a stock’s P/E, the cheaper the stock is. There are many nuances that are also in play when comparing two companies based on P/E, but this is most commonly used ratio.
Comparing companies by P/E within their own industry is most useful as many variables vary between industries. I have prepared a snapshot of the soft drink industry below. These numbers can be found directly in Yahoo! Finance.
Based on earnings, Pepsi is currently the cheapest stock and should then provide the highest value. Notice that Pepsi is also the stock with the highest share price. This analysis is meant to show that share price is not a determinant of value for a stock. Only when used in concert with another measure, in this case earnings, can you attempt to draw a relationship between stocks in a similar industry.