Cheap Stocks
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There can be several definitions of cheap stocks, since “cheap†is a relative word. For instance, Oracle’s shares may be considered cheap at $10, while Google’s shares may be considered cheap at $100.
How to Identify Cheap Stocks
There are four main methods used for identifying cheap stocks:
P/E ratio: Stocks with low price-to-earnings (P/E) ratios can be considered as cheap stocks. The P/E ratio is among the mostcommon metrics used for determining the value of a stock. It is the current share price divided by the company’s earnings pershare. For instance, if the P/E ratio for a company is 15, it means that investors are willing to pay $15 for every dollar ofearnings the company generates.
Book value: One could also consider the book value for identifying cheap shares. The book value is obtained by subtracting liabilities from assets. Stocks that are priced lower than their book value are cheap stocks.
PEG ratio: Some financial experts believe that the company’s price/earnings to growth (PEG) ratio is a better tool for stockanalysis than the P/E ratio. The PEG ratio is the ratio of the P/E to the company’s expected future earnings growth rate. A low PEG ratio indicates an undervalued or attractive stock. This is because a low PEG ratio indicates that the issuing company’s growth potential is not reflected by the share price.
DCF: One of the most technical methods for determining cheap stocks is comparing the share price to the fair value of the stock, as determined by the discounted cash flow (DCF) method. In this method, the company’s profits (dividends, earnings, or cash flows) are “discounted†to reflect the time value of money.
EV/EBITDA ratio: This is also called the Enterprise Multiple and is obtained by derived by dividing the enterprise value (EV) with the earnings before interest, taxes, depreciation and amortization (EBITDA). Stocks of companies having an enterprise multiple of less than six are considered cheap.
Cheap Stocks: What Else to Consider?
Even if a share appears cheap, it is better to invest in it only after considering the company’s earnings history, management team, balance sheet and credit rating. Cheap stocks represent good potential for capital appreciation. However, they are exposedto the same market volatility as any other stock.
