What does it mean when we say a stock is “expensive”?

While I was working for companies like Smith Barney and Oppenheimer, I would actually hear people say things like “$550 a share for Apple(AAPL)??? No. That’s way too expensive!!! I’d rather buy a less expensive stock—one that’s trading around $10 or $15 a share, like Groupon(GRPN).”

The thinking/rationalization goes something like this: “Well, if Apple is at $600, it has to go up $60 to be up 10%, but if Groupon is at $7, it only has to go up $.70 to be up 10%. It’s easier to go up $.70 than $55.” Of course, all of these prices are at the time of writing (23 July 2012), but even if they’re a little outdated the comparison is still valid.

Seriously? Wow.

Okay, just because a stock has a high absolute dollar price does not mean that it is more “expensive” than one that is selling in the low teens or single digits. In fact, it may be just the opposite. It may turn out that Groupon is much more expensive than Apple.

What we should really be looking at is the “relative valuation” of the two companies. Or, how does Apple’s valuation compare with Groupon’s when we take into consideration how much each company will earn? (We’re actually talking about the forward P/E ratio, but let’s not to get too technical!)

So, we need to look at two things for each company: How much is the company worth, and how much money will it make this year?

1) How much is the company worth?

In other words, how big is the whole enchilada? How much would it cost to buy the whole company? (This is how Warren Buffett learned to think about stocks from Benjamin Graham while he was earning his master’s degree at Columbia University, so you’re in good company.) To figure this out, we take the price that the stock is selling for and multiply it by the number of shares the company has outstanding. This is called the company’s “market capitalization.” Now you know.

For Apple, there are 935 million shares outstanding. If we multiply that by the price of $600, we get $560 billion.

For Groupon, there are 646 million shares outstanding. If we multiply that by the price of $7, we get $4.6 billion.

Now, $560 billion is indeed a much bigger number than $4.6 billion, but remember we’re talking about relative valuation here, not absolute price levels.

2) How much money will it make this year?

Granted, this is a highly subjective estimate unless you have a working crystal ball. Nevertheless, let’s give Wall Street’s intrepid analysts the benefit of the doubt. It may be worth noting that we could also look at what the companies actually earned in the most recently completed year or the four most recently reported quarters. These would be trailing P/E multiples and not estimates of future performance. For now, let’s stick with what we think the company will earn in the future since that’s what matters most to an investor.

For Apple, the average or consensus estimate for what Wall Street analysts think the company will earn this year is roughly $44 billion.

For Groupon, the average or consensus estimate for what Wall Street analysts think the company will earn this year is about $115 million.

So, what does it all mean?

Well, to cut to the chase, it turns out that Groupon at $7 actually is way more expensive than Apple at $600!

Apple is going to earn $44 billion this year and has a market capitalization of $514 billion, so it is trading for roughly 13 times what it will earn this year.

Groupon is going to earn $116 million this year and has a market capitalization of $4.6 billion, so it is trading for roughly 40 times what it will earn this year.

Said another way, Groupon is about three times more expensive than Apple, even though it has a relatively low $7 price tag when compared with Apple’s $600 stock price. Go figure!

This brings up some very interesting questions. Why would people be willing to pay $40 for $1 of Groupon earnings, but only $13 for every dollar that Apple earns? To be clear, that’s a big difference. Typically, that sort of gap is resolved in one of two ways: Either the company starts earning much more money (bringing the cost per dollar of earnings down), or the share price falls (which has the same effect).

Which do you think is more likely? Tweet me @SconsetCapital or let everyone know in the comments below.

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