A critical ability in succeeding in stock market investing involves understanding the concept of a “cheap stock.” Mastering this idea requires more than finding the lowest share price. Making money by buying cheap stocks involves not only understanding a stock’s price, it also means knowing what that price buys.
Cheap Stocks and Normal Stock Prices
The most critical concept investors need to understand is that price means very little. Suppose a company’s stock sells at $10 per share. By looking only at a price, the buyer only knows that one share costs $10. Price conveys no information on the number of shares outstanding, revenues, profits, long-term debt, or plant and equipment.
A company can also manipulate a stock price. In theory, a company could employ a 2:1 stock split. This changes nothing except that a company has twice as many shares at half of the previous value. What good is buying a share at half of its previous price if it holds 50% less value?
Start With Valuation
Thus, rather than trying to look for cheap stocks based purely on price, investors should seek “undervalued” stocks. However, investors sometimes find “undervalued” difficult to define. Most commonly, investors use the price-earnings (P/E) ratio. Like the name implies the P/E ratio divides the price of the stock by its annual earnings.
However, if a company loses money, it will not have a P/E ratio. In those cases, investors may use the price-to-sales (PS) ratio, a comparison of the company’s value to its revenues.
They may also employ the price-to-book (PB) ratio. The PB ratio compares the stock-based value of the company with the stockholders’ equity on the balance sheet.
Going back to the P/E ratio, if XYZ company trades for $10 per share and earns $1 per share in profit for the year, its P/E ratio would be 10. If a stock worth $10 per share earns $1 per share, this implies a 10% profit yield. Most investors would consider 10% an adequate rate of return.
Moreover, the average S&P 500 P/E ratio between 1957 and 2017 stands at about 18.6. Hence on the surface, a P/E ratio of 10 might appear undervalued.
Approach P/E Ratios Carefully
That said, a favorable P/E ratio may not necessarily serve as an indication to buy a stock. Those who look at enough stocks may continue to bid the stock price of Amazon (NASDAQ:AMZN) higher even though its P/E exceeds 200. They also might sell off stock in Ford (NYSE:F) even when it trades below six times earnings.
Such disparities often occur when stocks see different rates of profit growth. For this reason, many evaluate stocks by their price-to-earnings-to-growth (PEG) ratio. The average PEG ratio stands at around 1.33. From the previous example, if our $10 per share stock grew its profits at 10% per year, that would imply a PEG ratio of 1.
While a low PEG ratio may appear to serve as a buy signal, knowing both the company and the industry also remains critical. Even with steady growth, conditions such as high debt levels, geopolitical events, labor disputes, severe weather events, or other occurrences can change a stock’s valuation perspective.
This makes valuation as much art as it is science. However, with the high liquidity and research options regarding stocks, investors can employ multiple options to manage such risks.
The Bottom Line on Cheap Stocks
Finding cheap stocks means understanding what the price of a stock buys in terms of value. Both the number of shares of a stock and its price starts out at arbitrary levels.
Hence, investors do not find cheap stocks by finding the lowest share prices. Comparing prices to earnings (or sometimes sales or stockholders’ equity) serves as a better measure. Investors also need to consider growth and other factors besides P/E ratios.
However, the focus needs to rest on value not price. By understanding the true nature of cheap stocks, investors can avoid paying the high cost of low-priced stocks and instead, earn higher returns.
As of this writing, Will Healy did not hold a position in any of the aforementioned stocks. You can follow Will on Twitter at @HealyWriting.