The Best Stocks To Buy Right NOW
One of the biggest mistakes investors make — especially beginners — is assuming that a low price means a stock is cheap. For a litany of reasons, including how much of the company each share is worth and how big the company is in terms of revenues and earnings, sometimes a $5 stock is actually more “expensive” than a $50 stock. Moreover, “cheap” can mean different things depending on the metric being used to value a stock and what it’s being compared against. And that’s before we even consider a company’s growth potential, dividend yield, or other aspects of its business that could affect its stock price.
In other words, a cheap price doesn’t always equal a cheap stock; in many cases, the stocks trading for the lowest stock price actually have some of the highest risk and limited likelihood of helping you make money. Below is a quick primer on how investors can find the real bargains in the stock market, using measures such as price-to-earnings ratio, cash flows, or asset value to value a stock and factoring in a company’s growth potential and dividend yield to identify whether they make the mark as cheap.
What is a cheap stock?
A cheap stock trades for a discount to one or more measures of valuation such as price-to-earnings (or P/E) ratio, cash flows, or the book value of its assets when compared either to its historical value or to that of similar companies. In other words, the first step is to move beyond the stock price — which is frankly meaningless as a stand-alone measure of value — and use metrics that normalize for variations in share price, share count, and a company’s market value.
How can I tell whether a stock is cheap?
In general terms, a company’s value, and hence the value of its stock, is tied to its earnings capacity, cash flows, and the value of the assets it owns. For this reason, and since different metrics are appropriate from one industry to another, it’s important to have a decent understanding of some key metrics and what they can tell you.
The price-to-earnings ratio is a simple formula: share price divided by earnings per share. This metric “normalizes” a company’s earnings capacity for its stock price and share count. The resulting P/E ratio can then be used to compare a company’s valuation to that of its competitors, its industry average, or its historical valuation. Since a company’s ability to generate earnings is typically the most important measure of its worth, this is a go-to metric when looking for cheap stocks.
In general, there are two different kinds of P/E ratio: trailing and forward. The trailing P/E ratio typically measures a company’s earnings over the past 12 reported financial months, while the forward P/E is generally the average estimated earnings supplied by Wall Street analysts who follow the company. If a company offers guidance for future earnings, investors can use it to determine a forward P/E against what management expects the company to earn.
Earnings don’t always equal cash: Various accounting requirements such as depreciation and amortization can spread the impact of big cash expenditures over multiple years on the earnings statement. Moreover, it’s important to understand how a company generated its cash — did it sell off assets, or did the cash come from operations? — as well as how much it generated. There are several different ways to measure a company’s cash flows, but cash from operations and free cash flow are two of the best.
Cash from operations
Also called operating cash flow, it’s exactly what it sounds like: how much cash a company makes from its core business operations. This number can be found on a company’s cash flow statement in its quarterly 10-Q and annual 10-K filings. To better explain what it is, we can look at other ways a company may generate (or consume) cash that aren’t from operations. Investing activities, including selling or acquiring assets such as property, equipment, or even stocks and bonds, can make or cost a company cash. So can financing activities, including a company’s efforts to raise capital, such as issuing or repurchasing company stock, issuing or paying off debt, and making dividend payments.
In short, by removing the cash flows (or cash consumption) from these nonoperations activities, investors can get a better idea of a company’s ability to generate cash from its core business.
Like the P/E ratio, there’s a formula to normalize this metric, called price-to-cash from operations per share, or price-to-CFO per share for short. To find it, just divide price by CFO per share.
Free cash flow
This measure takes cash from operations one step further with the following formula: Cash from operations minus capital expenditures (capex) equals free cash flow. After you subtract capital expenditures — what a company spends to maintain existing assets and purchase new ones — the resulting measure essentially shows you how much cash a company has left over to do with as it chooses.
Similar to cash from operations, investors can normalize this measure to the share price with the same formula as above. However, since capital expenditures can vary greatly for many companies from one period to the next, this metric requires more analysis of a company’s capex spending with an eye on the long-term trends. One year of low capex spending can make a stock look cheaper than it might actually be, particularly if this year’s capex reduction will result in higher capex spending in the future.
While the metrics above focus on a company’s ability to make money, book value measures the value of a company’s assets after subtracting all of its liabilities. What’s left over is its book value. This is generally expressed on a per-share basis. For valuation purposes, it’s called price-to-book value ratio, or simply P/B.
One of the oldest and most commonly used value measures, price-to-book value can be an excellent tool to identify potential bargains by comparing a company’s book value to its historical multiple or to that of similar peers.
However, it’s worth noting that a company’s book value can change, and just because a stock sells for a discount to book value — anything less than 1 times book value means a stock sells for less than the book value of a company’s assets — that doesn’t guarantee that it’s cheap.
That’s particularly true if a company isn’t profitable (it may have to sell assets or take on debt to raise capital, diluting per-share book value) or if the carrying value of its assets on the balance sheet doesn’t reflect their real market value (for example, if a company closes a factory, writing down the value of its assets as a result).
In summary, book value can be a valuable tool, particularly for industries with hard assets that are more straightforward to value. Just take the time to put in the work to make sure there’s real value to back it up.
How to find cheap stocks
A good place to start is using a stock screener, which is a tool to search for stocks based on certain parameters. For instance, if one were to run a screener looking at retailers based on P/E ratio, Kohl’s would look cheap, trading for 13.6 times trailing earnings and 10.9 times forward earnings estimates. That same screener would also show TJX Companies (NYSE:TJX) and Ross Stores (NASDAQ:ROST) trading for much higher P/E multiples: above 21 times trailing earnings and 20 times forward earnings estimates.
But at this point, we’re only talking about numbers on a screen and not considering what they mean in relation to three different businesses. This is where you take what the screener gives you as a starting point and do some actual analysis.
To put it simply, Kohl’s stock should trade at a lower valuation than Ross and TJX based on the differences in their businesses and the fact that the two discounters are thriving in the e-commerce shift while Kohl’s is, if not struggling, then certainly in the midst of a transition.
But should Kohl’s trade for such a discount to its faster-growing, closeout-focused peers? A metric we can use to help determine this is the PEG ratio, or price-to-earnings growth ratio.
Cheap stocks can make you money, but diversify and expect to be wrong sometimes
It can be a lot of fun — and quite profitable — to find a great stock on the cheap. However, investing is an inexact science, and you’re bound to buy a company that looks like a bargain to you but ends up losing even more value when the thesis plays out and it turns out you missed something important.
That’s OK; no investor gets it right every time. This is the main reason why successful investing requires some degree of diversification. Even if you make a terrible pick and buy shares of a company that goes belly-up, getting it right on another high-quality business can deliver returns that more than make up for the occasional flub.
Moreover, consider the risks for each company just as deeply as the upside. Not only can this help you uncover weaknesses you may have overlooked in your optimism, but it can also help you maintain discipline and not risk more money on any single stock than you’re willing to lose if things go bad.
Src: The Motley Fool