There are a slew of misconceptions that rookie investors have about stock picking, but the most common and most notable relate to the price of the stock.
First thing: the price of the stock has no relation to the underlying value of the stock. That is not to say that any stock should be bought at any price, but an investor cannot conclude anything about the value of the stock from the price alone.
The most common mistake looks something like this: Blockbuster video (BBI) is trading at around $0.30 and is a lot “cheaper” than Johnson and Johnson (JNJ) which is trading at over $60. The thought process would go like this: “I can buy way more shares for my money and it wouldn’t be hard to double it, the stock just has to get up to $0.60.”
This could not be more wrong. It is true that you can get many more shares of Blockbuster than Johnson and Johnson, but realistically it is probably more likely JNJ will double long before BBI will.
The judgment of how “cheap” or “expensive” a stock truly is, relates to the amount of earnings the company produces versus the stock price.
Blockbuster is burning through cash reserves quarter after quarter and continuously turning in negative earnings, while Johnson and Johnson produces over $4 per share of real tangible earnings annually.
The general rule of thumb is that stock prices drop below $5 or into “penny-stock” territory for good reason. This area is widely known on Wall Street as the place stocks go to die. It is where the mighty auto-giant General Motors was trading right before bankruptcy.
There is a reason why many mutual fund managers are prohibited from purchasing stocks at these low price levels.
This is not to say that distressed companies that have seen their stock price plummet can never turn it around and present promising investment opportunities.
It is much more likely that investing in these companies will result in more loses than gains.
When investing your hard earned money, give your stock choices more thought than solely basing it on stock price.
If you were buying a used car you most likely would not spend a large sum of money on the cheapest junker out there expecting a quality car that will last.
When picking stocks take notice of the price but also look at the earnings. Look deeper into the company, what do they do?Do you believe in the company? Does it have room to continue to grow in its market in the future?
These questions are much more important than “What is the price?”
