Everyone loves a bargain. We spend countless hours hunting around for the lowest price for that TV we want to buy or look for discounts on our favorite foods. The stock market is no different. Many people hunt for cheap stocks. But what do cheap stocks really mean?
What Are Cheap Stocks?
Many new investors look for cheap stocks based on price, usually under $5. Typically, penny stocks like this represent a significant amount of risk to the investor. The stock price might be low, but it usually does not represent good value for money. This is the number one rookie mistake.
A stock might be cheap, depending on what you are looking for.
In fact, anything might be cheap, based on several reasons. A Ferrari might be cheap because the seller wants a quick sale, it might cost $50,000 still, but relatively that might still be a bargain.
A washing machine might be cheap because the demand for washing machines has dropped, and the manufacturer needs to get rid of surplus stock and lowers the price. A dishwasher might be cheap because its manufacturer uses inferior materials and labor to undercut the competition, and the product may be a poorly designed, low-quality piece of junk.
Cheap is definitely in the eye of the beholder.
How to Find Cheap Stocks?
Depending on what you are looking for, you can find cheap stocks everywhere you look. However, most people look for their specific version of cheap. This is one of the single biggest mistakes most amateurs make.
1. Find Cheap Stocks Based On A Low Stock Price
Finding cheaps stocks based on a low stock price alone is a recipe for disaster; the stock price by itself is a meaningless measure. In this section, I will share research that proves this point.
This is where most beginners to the stock market look first. People take the same ideas about bargain hunting from the real world into the stock market. International Frontier Resources (Ticker: IFRTF) has a share price of $0.01, which sounds really cheap compared to one of the highest-priced stocks on the US stock market, Google (Ticker: GOOG), priced at $1482.83.
But just because IFRTF has a stock price of 1 cent does not make it cheap, neither does the stock price of Google makes it expensive.
Google has averaged a 26% gain for the last five years to 2020. What a great investment that was. Would you consider that cheap?
IFRTF hit a price high in 2017 of 30 cents per share and has lost over 97% of its value in 3 years to 2020. The company must have done many things very badly to lose over 97% of its value. You could say it is now very cheap, but it has had no revenue growth over the past five years and indeed does not look to have made a profit in this time-frame either.
If this stock continues down and goes bankrupt, this means you will lose your entire investment. That does not make it cheap, which makes it very expensive and extremely risky.
The Cheap Stock Price Experiment
Using the excellent TradingView Stock Screener, I examined the price performance of all US stocks over the past year. I analyzed stocks with a stock price lower than $5, lower than $10, and those with a price of higher than $10.
Performance of Stocks Priced Lower Than $5
Stocks with a price lower than $5 – how many beat the performance of the S&P-500 by more than +10% = 891
Stocks with a price lower than $5 – how many were worse than the performance of the S&P-500 by more than (minus) -10% = 1571
Buying stocks with a price lower than $5, you would mean you would have nearly twice as many losers to gainers.
Performance of Stocks Priced Lower Than $10
Stocks with a price lower than $10 – how many beat the performance of the S&P-500 by more than +10% = 1270
Stocks with a price lower than $10 – how many were worse than the performance of the S&P-500 by more than (minus) -10% = 1850
Buying stocks with a price lower than $10 would have a 59% chance of losing on average.
Performance of Stocks Priced Higher Than $10
Stocks with a price higher than $10 – how many beat the performance of the S&P-500 by more than +10% = 1265
Stocks with a price higher than $10 – how many were worse than the performance of the S&P-500 by more than (minus) -10% = 572
Buying stocks with a stock price higher than $10, you would have had a 67% chance of beating the SP-500 average, e.g., beating the market.
The key here is not the stock price but the expected returns.
This was a simple experiment to show that the stock price is meaningless, and in fact, there is probably less chance of finding high performance with a stock priced lower than $5 or $10.
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2. Find Cheap Stocks Based on Historical & Future Earnings
Earnings & Revenue Growth are key in this strategy. A simple way to value a stock is to look at its historical and future earnings. Let us take another look at Google, the 5th highest-priced stock in the US Stock Market.
Google Inc. has a five-year expected sales growth of 20% and expected EPS for 2021 of 31%. Google also has a P/E Ratio (The Stock Price Per Share / Earnings Per Share) of only 31.
If we expect Google’s earnings growth to continue at this rate into the future, combined with the P/E valuation of 31 and the expected earnings growth of 30%, we could say that Google is cheap, even though it does have a high share price.
Did the piece about the P/E Ratio confuse you? If so, read this article on the PE Ratio.
3. Find Bargain Stocks Based on Asset Valuation
You could base your opinion on whether a stock is cheap or not on simple asset valuation or even base it on how much the current assets and cash in the company’s bank are worth.
For example, let’s assume a company has 50 million shares outstanding. Let’s also assume that this company has $150 million cash in the bank in short-term investments (Current Assets) if the stock price is $3 per share. If we divide the current assets worth $150 million by the outstanding shares of 50 million, we actually get a Cash Per Share of $3. If the stock price is $2, then you have essentially found an amazingly cheap investment, providing the company is not swamped in debt or massive pending liabilities.
If the Cash per Share is $3 and the Stock Price is $2, you are getting the stock at a 33% discount.
Any reasonably healthy company’s stock price will usually not fall below the value of the cash and current assets it holds. Was that a little difficult to grasp? I have defined a detailed strategy for finding these types of stocks in the Liberated Stock Trader PRO Training Course.
4. Find Cheap Stocks Based on Discounted Cash Flow
Value investing is the method employed by legendary investors such as Buffett, Klarman & Munger. It is considered the gold standard in finding investments that represent great value to the investor. By estimating and discounting a company’s ten-year cash flow and dividing it by the outstanding number of shares, you arrive at a fair value for the company. If that fair value per share is less than the current stock price, you essentially have a Margin of Safety.
A Margin of Safety greater than 30% is the best way to find cheap stocks
Fair Value & Margin of Safety Warren Buffett Strategy – Low Risk
|Fair Value & Margin of Safety Buffett Strategy Screening Criteria
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Probably Buffett’s most important measure to decide whether to invest in a company the Margin of Safety is the percentage difference between a company’s Fair Value and its actual stock price. This metric is the single most significant valuation metric in our arsenal, as it is the final output of detailed discounted cash flow analysis.
Fair Value Warren Buffett bases his Intrinsic Value / Fair Value calculations on future free cash flows. To explain, Buffett thinks cash is a company’s most important asset, so he tries to project how much future cash a business will generate and discount it against inflation. This is called the Discounted Cashflow Method.
A Strong Earnings Per Share History & Growth Rate. It will come as no surprise that earnings per share (EPS) is an important metric for Buffett and Wall Street. Buffett looks for companies with a consistent track record of earnings growth, particularly over a 5 to 10 year period.
A Consistently High Return on Equity. This is a profitability measure calculated as net income as a percentage of shareholders’ equity, also called ROE. A high ROE shows an effective use of investor’s money to grow the value of the business.
Return on Invested Capital (ROIC) quantifies how well a company generates cash flow relative to the capital it has invested in its business.
Is the Company Conservatively Financed? The solvency ratio is a measure of whether a company generates enough cash to stay solvent. It is calculated by summing net income and depreciation and dividing by current liabilities and long-term debt. A value above 20% is considered good.
If a company cannot make a profit per share higher than the return of a safe asset like treasury bonds, you should not invest in it. This is an easy calculation, and we will use the Earnings Yield. Earnings Yield is the earnings per share for the most recent 12-month period divided by the current market price per share.
More Value Investing Strategies in Our Guide, “7 Value Investing Strategies & How To Set Them Up.”
I have read the bible on value investing; it is called the Intelligent Investor by Benjamin Graham, an excellent book.
Summary: Are Cheap Stocks Good Value for Money?
Do not think that a stock is cheap because its dollar price is below a certain value.
Think about the quality of a company and the fundamentals before you judge a stock to be cheap. You need to consider the investment if a company is low priced carefully. Also, you may increase your exposure to volatility if a company is struggling; the market conditions may even impact you.
Low price stocks, penny stocks, and micro-cap stocks are low priced for a reason. Usually:
- Bad management
- Failure to adapt to changing market conditions
- A shrinking market
- Uncompetitive products
- Bad financial management
Video: Cheap Stocks
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