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.
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 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, 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 very 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 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 stock screener Stock Rover I examined the price performance of all US Stocks over the past year to date 2010. We analyzed stocks with a stock price of lower than $5, lower than $10, and those with a price of higher than $10.
Stock Price 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
This means that if you had randomly bought stocks with a price lower than $5, you would have had nearly twice as many losers to gainers.
Stock Price 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 that buying stocks with a price lower than $10 would have a 59% chance of losing on average.
Stock Price 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.
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 now than it was in November 2007. Does that make it cheap…maybe? However, it has a five year revenue growth of 43%, and 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
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 even base it on how much the current assets and cash in the bank of the company 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, then 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.
Cheap Stocks Summary
Do not think that 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 stock are low priced for a reason. Usually:
- Bad management
- Failure to adapt to changing market conditions
- A shrinking market
- Uncompetitive products
- Bad financial management
In this section, we looked at stock analysis and how it is done. We also looked at how to assess the market direction, also known as Dow Theory. We then moved onto the stock market rating agencies and then 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.