IF YOU SPEND enough time at cocktail parties, you'll eventually run into someone boasting about his latest "bargain" stock or the hot company he managed to pick up "cheap." And as the ice melts in your glass, he'll probably ramble on about his superior stock-picking skills and all the winners he's found in the past.
Tedious? Guys like that are. But there's nothing boring about a good, cheap stock. More than anything else, learning to spot bargains is the essence of successful investing.
Many beginning investors make the mistake of thinking that a low stock price means the company is inexpensive. If, for instance, consumer product Company A is selling for $50 a share and consumer product Company B is selling for $50 then the two must be more or less equally valued, right? Not necessarily. Share price is total market value divided by shares outstanding. And since the number of shares is largely arbitrary, so is the stock price. Company A may have a total market value of $50 million and a million shares outstanding, while Company B may have a market value of $1 million and 20,000 outstanding shares.
The crucial consideration is why the market believes one company to have a value of $50 million and the other to be worth $1 million. And that's a lot more complicated.
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|Source: First Call|
See our Bonds A stock's value proposition starts there: How much more will it return than a Treasury bond, and at what risk?
When you buy a stock, your return is a stream of earnings over time. The more reliable and fast growing a company's earnings stream is, the more investors will be willing to pay for it (see applet). Your traditional electric utility may have reliable earnings, but utilities' earnings generally don't grow very fast, so they tend to be pretty sleepy stocks. A nimble, innovative technology firm, on the other hand, is more likely to have earnings that are both steady and fast-growing, giving its stock the potential to deliver some juicy returns.
In order to evaluate companies against each other (and against themselves), investors long ago developed a measure called the price/earnings ratio, or P/E. It's derived by dividing a company's price per share by its earnings per share. If a company has a P/E ratio of 20:1 (usually displayed as just 20), for instance, that means investors are paying $20 for every $1 of earnings. If the P/E is 18:1, they're only willing to pay $18 for that same $1 profit. The ratio is also known as a stock's "multiple," as in Company A is trading at a multiple of 30 times earnings and Company B, at 20 times earnings. Translation? Investors are paying more for a slice of Company A's profits.
A company's P/E fluctuates with investor perceptions about how quickly its earnings will grow in the future. That's why two companies with the exact same earnings per share over the past year may have different multiples. If Company A and Company B each earn $1 a share, but Company A is trading for $20 and Company B is trading for just $18, the market is making a judgment on their earnings prospects. Based on any number of factors -- company health, outside competition, better management, the economy, the outlook for the sector -- investors think Company A's earnings are better poised for growth. Consequently, they're willing to pay $2 more right now to lay claim to them.
OK, so we still haven't really answered the question: What is a cheap stock? For that we have to look at a stock's behavior over time. Most established companies trade up and down in a range depending on how investors are weighing their earnings prospects. Sometimes disappointing news -- a lackluster quarterly-earnings report, for instance -- can depress the stock price for a period of time. Other times good news sparks a flood of investor interest.
This ebb and flow is reflected in the company s P/E, which can be compared with its historical range, as well as the P/E of other companies in its industry and the market as a whole. In the telecommunications sector, you may find a company trading at a low multiple relative to the average for the industry. At first blush, the stock may look cheap, but if you dig deeper you may find that it is facing enormous competition in a critical part of it business, and that such companies often trade at a discount to the broader market because their earnings are so cyclical.
A defense company, on the other hand, may look expensive trading at around 20 times earnings projections. But a closer look may reveal that the company gets a huge percentage of its revenues from sales of defense-related wares that have been in higher-than-usual demand. Faced with this evidence, you might conclude that while the company looks fully valued, it is ripe for the picking if its price falls temporarily. The object of investing is to buy low and sell high. And as you can see, that often means looking for stocks that are temporarily out of favor. If you buy stocks near the top of their range, the danger is that they will reverse course and tumble. If you buy near the bottom or when the stock is cheap relative to its true potential, you can enjoy the full ride back upward. (The trick, of course, is to do careful research so you can be confident the stock will, in fact, head north once again.) The art of investing is deciding when to strike, and then acting on that decision before everybody else does. We'll show you how in our Strategic Investing section.