102-21 What are Cheap Stocks and Should You Buy Them?

Cheap stocks can be a good way to get started in the stock market. You can find cheap stocks by looking for companies that are undervalued by the market.

Everyone loves a bargain. We spend countless hours hunting for the lowest price for that TV we want to buy or looking 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?

Course 102 - Stock Market Investing
What are Cheap Stocks and Should You Buy Them?

What are Cheap Stocks?

Cheap stocks are simply stocks of public companies that trade at relatively low prices. The prices of these stocks are usually low because the company is not doing well, or it is a small company that is not well known.

Are Cheap Stocks Worth Buying?

That depends on how your approach to investing. If you are a value investor, you believe these stocks are undervalued and have the potential to go up in price.

On the other hand, if you are a growth investor, you may not be as interested in cheap stocks because you are more focused on companies that are growing quickly.

So, what is the right answer? It depends on your investing strategy and what you are looking for in a stock. If you are willing to take on more risk, then cheap stocks may be a good option for you.

Just remember to do your research before buying any stock, cheap or otherwise.

What are the benefits of buying cheap stocks?

There are two main benefits of buying cheap stocks. First, you have the potential to make a lot of money if the stock price goes up. Second, since the stock price is already low, you don’t have as much to lose if the stock price goes down.

What are the risks of buying cheap stocks?

There are also two main risks of buying cheap stocks. First, since the stock price is already low, there is less room for the stock price to go up. Second, since these companies are not doing well, they may go out of business, which would mean you would lose all of your investment.

Should you buy cheap stocks?

The answer to this question depends on your investment strategy and what you are looking for in a stock. If you are willing to take on more risk, cheap stocks may be a good option. Just remember to do your research before buying any stock, cheap or otherwise.

What is a cheap stock? How do you know if a stock is cheap? Cheap stocks are not always what they seem; in this section, we look at what makes a good stock value, not just high risk.


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What does “Cheap Stock” really mean?

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 even 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.

What types of cheap stocks exist?

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.

Cheap stocks based on a low stock price

This is where most beginners to the stock market begin. People take the same ideas about bargain hunting from the real world into the stock market. Evergreen Energy Inc (Ticker: EEE) has a share price of $0.20, which sounds cheap compared to one of the higher-priced stocks on the US stock market, Google (Ticker: GOOG), priced at $489.83. But just because EEE has a stock price of 20 cents does not make it cheap, and neither does the stock price of GOOG make it expensive.

Google’s historical price high was circa $747 back in November 2007; since then, it hit a low of $259; at $259, it could be considered cheap, as, in less than two years, it has nearly doubled in price.

Evergreen Energy hit a price high in 2006 of $21.49 and has lost over 99% of its value. The company must have done many things badly to lose over 99% of its value. You could say it is now very cheap, but it has had no revenue growth over the past five years and 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; actually, it’s very expensive and extremely risky.

The cheap stock price experiment

Using the excellent stock screener Stock Rover, I examined the price performance of all US Stocks over the past year to date, 2022. We analyzed stocks with a stock price of lower than $5, lower than $10, and those with a price of higher than $10.

Cheap Stocks – Prices 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

If you had randomly bought stocks with a price lower than $5, you would have had nearly twice as many losers as gainers.

Cheap Stocks – Prices 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

This means buying stocks with a price lower than $10 would have a 59% chance of losing on average.

Cheap Stocks – Prices 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

Interestingly, if you had randomly bought 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.

You see, 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 there is probably less chance of finding high performance with a stock priced lower than $5 or $10. 

Caution – Do not base an entire investing strategy on this test. 

 

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Cheap stocks based on historical and future earnings

Earnings & Revenue Growth

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 share in the US Stock Market.

Google is currently about 34% cheaper than in November 2007. Does that make it cheap…maybe? However, it has five-year revenue growth of 43%, EPS percentage changes the latest year of 61%, and a P/E Ratio (The Stock Price per Share / Earnings per Share) of only 21. Now, if we expect Google’s earnings growth to continue at this rate into the future, combined with the P/E valuation of only 21 and the expected earnings growth of 40%, then we could say that Google is very cheap, even though it does have a high share price.

Cheap stocks based on asset valuation

Value investing

The bible on value investing is called the Intelligent Investor by Benjamin Graham, and it is an excellent book.

You could base your opinion on whether a stock is cheap or not on simple asset valuation or on how much the company’s current assets and cash in the 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 of this company is $3 per share. Then if we divide the current assets worth $150 million by the outstanding shares of 50 million, we get a cash per-share value of $3. If the stock price is $3, you have essentially found a fantastic value investment (providing the company is not swamped in debt or massive pending liabilities).

The stock price of any reasonably good company will usually not fall below the value of the cash and current assets it holds.

How To Find Undervalued Stocks Like a Pro Value Investor

Cheap Stocks Summary

Do not think a stock is cheap because its dollar price is below a specific value. Think about the quality of a company and the fundamentals before you judge a stock to be cheap

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

Further Reading – 4 Ways to Find Cheap Stocks

4 Great Ways To Find Cheap Stocks to Buy Today

Is The Stock Market Overvalued? In-Depth Analysis

Lesson Section Summary

In this section, we looked at stock analysis and how it is done. We also looked at how to assess the market direction, known as Dow Theory. We then moved on to the stock market rating agencies and introduced you to fundamental analysis.

We then covered the three important documents you need to understand, the balance sheet, the income statement, and the cash flow statement.

Finally, we discussed two important concepts you need to grasp, earnings per share and the price-earnings ratio.

 

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