Signs You May Have Found a Cheap Stock
Quick and Easy Ways to Roughly Screen for Value Stocks
If you are interested in finding a cheap stock - one that might offer you more value than the current market price reflects - there are a handful of signs that have historically correlated with above average returns. While no one can ever be sure what any individual equity will do, as a class, the academic evidence is overwhelming that undervalued holdings can make their owners a lot of money. The trick to finding them is to seek out the characteristics they tend to exhibit as a sort of detection system.
While not every stock that shows these markers will be a winner, they can be a wonderful place to start researching investing ideas. In this article, we'll go over six of the more common traits found in cheap stocks that can serve as a rough screening tool for you to narrow down the field of potential additions to your own family's investment portfolio.
1. A Cheap Stock Sometimes Has a Low Price-to-Earnings Ratio
While this is often oversimplified to the point that it can be dangerous to the inexperienced - for example, cyclical companies appear to have low p/e ratios at the very moment they are overvalued due to the nature of the industries in which they operate - the p/e ratio still works for widely diversified collections of securities. All else equal, when you pay less for $1 in earnings, it takes a shorter amount of time for the business to repay your initial investment and begin returning surplus wealth.
If things turn around and business picks up or new management revolutionizes the company's income statement for the better, the shareholder often enjoys a double-bump from the higher underlying net income and the higher valuation multiple applied to the stock.
2. A Cheap Stock Sometimes Has a Low Price-to-Book Ratio
Book value is sometimes referred to as shareholder equity. Though it tends to only happen in times of severe economic stress, it is possible for a corporation's stock price to fall below book value, meaning the stockholder has a chance to buy into the firm for less than the accounting basis of the net assets. If things turn around, this can be a huge windfall, albeit one that takes years to manifest. If things don't, you could experience the devastation stockholders in a bank like Wachovia did when the stock went to $0 despite enjoying a $38 book value.
The general rule for buying cheap stocks on a book value basis is to own them as a basket rather than try to pick individual winners. To use a classic example from value investing, horse and buggy manufacturers were cheap when Henry Ford began selling the Model T. It turns out, they were cheap for a reason and the subsequent experience for their owners was not always pleasant unless management had the foresight to get into another business.
3. A Cheap Stock Sometimes Has a Low PEG or Dividend Adjusted PEG Ratio
The problem with looking at the p/e ratio or book value alone is that it doesn't factor in growth. To get around this, investors who want to find a cheap stock often calculate something known as the PEG ratio.
It, however, had its own drawback as it didn't include the dividends mailed out to stockholders each year, which accounted for a huge percentage of aggregate wealth creation in the stock market. The solution was the development of a new, improved financial ratio called the dividend adjusted PEG.
In most situations, a PEG ratio or dividend-adjusted PEG ratio of 1.0 or less is considered a great deal, with 2.0 being the highest anyone should reasonably consider paying unless they want to risk subpar returns. The tricky part is to get the growth estimates right as they will directly influence the final value.
4. A Cheap Stock Sometimes Has a Low Price to Free Cash Flow Ratio
This one is a bit harder for the inexperienced investor to grasp because calculating free cash flow is not a simple thing.
I once covered a cash flow valuation method on my personal blog, but it's not the sort of metric you can get by pulling up a quick stock quote or that is appropriate for those who consider themselves beginners. It requires accounting knowledge and detective work. Still, it's the only way to really dig into a company and know for certain that you've found a cheap stock.
5. A Cheap Stock Sometimes Has Cyclically Adjusted Earnings Yield of 2x Long-Term Treasury Rates
If a business has an earnings yield that is double the rate on the long-term Treasury bond, and the earnings are expected to at least grow at the rate of inflation over the coming decade, it can be a neon sign that you've found a cheap stock. Dr. Jeremy Siegel at Wharton's business school has done some excellent research into this area, finding that low value stocks with consistent earnings perform better over long stretches of time than their more richly valued, higher growth counterparts. He's written about it extensively in his books, which are worth reading if you are interested in successful strategies for long-term, conservative investors. A person can get very rich if he or she has a long enough stretch of time and a stake in boring, profitable, cheap enterprises.
6. A Cheap Stock Sometimes Has a High Dividend Yield
Finally, a sign that you might have found a cheap stock is when the business offers a dividend yield much higher than the average stock, yet it still has a dividend payout ratio of less than 50% to 60%. Though unlikely to grow quickly, these can be big generators of passive income for your family and help provide a cushion against catastrophic stock market crashes like the one seen between 1929-1933 or 1973-1974. Part of the return calculation will depend on whether you are holding the stock in a tax shelter such as a Roth IRA or 401(k) plan, or you have them parked in a brokerage account where they will be subject to Federal, state, and local taxes depending on where you live.