Stock trading is about buying low and selling high. Finding cheap and undervalued stocks is one investing method outlined here.
Many people think an undervalued or cheap stock means one with a low share price. Does this necessarily make a stock “cheap”? Imagine that bananas sell for 89 cents a pound. If you were sold half a pound for 50 cents, is that really a good bargain? Hardly. So how do we find cheap stocks?
What a Cheap Stock Is
For our purposes, a cheap stock will be one trading a low prices compared to its actual intrinsic value, when compared to its peers, or when compared to its future growth expectations. How do you screen or scan for these three different scenarios?
Low Prices When Compared to Book Value
A stock may have a net asset value of $10 per share. What if the stock is trading at $5 per share? If the company went bankrupt tomorrow and the assets were liquidated, the shareholder could theoretically double his investment. Thus, he feels that the share price of $5 is unfair, undervalued, and thus cheap.
This is considered a low price to book value. Any stock with a price to book value less than one has a net asset value higher than the market price.
Relatively Undervalued Shares
The second scenario can occur with any sort of stock, including high growth companies. This valuation technique is most often performed using price to earnings ratios. Price to earnings is simply the share price divided by the earnings per share. Different sectors and industry groups will have different average PE ratios. If you have a stock with decent future growth prospects but with low PE valuations when compared to its peers, your stock could be undervalued.
Of course, the contrary opinion is that the stock is priced lower due to other factors such as future earnings risk or some other fundamental caveat. But when looking for undervalued shares, scanning for PE ratios below the industry average may be a good starting point.
Cheap Stock When Compared to Future Growth
A stock may also be considered undervalued when comparing price to earnings ratios with future growth prospects. Peter Lynch, a famous Wall Street stock investor, and author of the book “One Up on Wall Street,” is well-known for his treatment of the PEG ratio. In a nutshell, he suggests that the future growth of a stock should equal its price to earnings ratio. What does this mean?
- A stock with an average expected growth of 20% per year should have a PE of 20
- A stock with an average expected growth of 50% per year should have a PE of 50
If a stock had a five-year expected growth rate of 30% per year, and the price to earnings ratio was only 20, this could be considered undervalued when compared to its future growth prospects. You can scan for PEG(price to earnings divided by growth) ratios under one with many online stock screening tools.
Are Cheap Stocks Always Cheap?
Finally there is the question of whether undervalued stocks or cheap stocks are really that cheap. Some would say that they are fairly priced due to some problem with the stock, such as sliding profit margins or earnings growth. Yet, Warren Buffett takes a different view. He first finds wonderful stocks with smart management and high fundamental strength, and then buys heavily when the market pushes the price down to undervalued levels. Picking boring stocks, ones without high press coverage and glamor, also may have lower valuations due to reduced investor interest.
In the end, whether you choose to buy cheap and undervalued stocks or not, always do your due diligence to make sure you are not buying a low-priced seat on a hot air balloon that just popped.