What is a cheap price for a stock
Do you think a $2, $5 or $8 dollar stock is a cheap stock? Well, if your answer is yes, don’t worry, it is mistake that several people commit. We need to consider that when buying stocks, we are purchasing a piece of a company, a small slice of the company. And since companies do not have the same number of outstanding shares or earnings, you cannot decide whether it is cheap or not by considering only the share price.
Just as you cannot judge a good book by its cover, when determining if a stock is a good investment or not, you need to “read the stock”. You need to analyze the company fundamentals and determine if the share price is below the intrinsic value of the stock (read more on fundamental analysis). Several factors have to be considered. One of these is the market capitalization, which is how much the market values the company at a specific point in time. It is calculated by multiplying the share price by the total number of outstanding shares.
For example, if Company A has a market capitalization of $10B for a total of $1B shares outstanding and Company B has a market cap of $1B for a total of 100M shares outstanding, the share price of both companies would be the same ($10) but company A is worth 10 times more than Company B. When selecting a stock to invest in, several factors need to be considered. These include revenue (is it growing?), margins (are they deteriorating?), the amount of debt, profit, etc.
Stock splits and reverse splits
At times, the board of directors of publicly traded companies decide to make the share price more attractive to investors by either splitting the stock or reverse splitting the stock.
It is important to mention that when a stock split or reverse split occurs, the market capitalization remains the same. For example, when a 2-for-1 stock split occurs, the share price will be halved (because the number of outstanding shares has doubled). Following the decrease in share price immediately after a stock split, it is not uncommon to see the price appreciate. This is because the lower share price makes it more attractive to the small investors (yes, psychology is very powerful).
Using the P/E (price-to-earnings ratio)
One quick way to evaluate if a stock is expensive or not is to use the P/E ratio. This ratio is calculated by dividing the current share price by the earnings per share (EPS). Such metric tells you more about how the investors value the stock. If the EPS remains constant but the price appreciates, the P/E will rise. If a stock’s P/E continues to rise, at a certain point it will be considered “expensive” (sell recommendation). But at which P/E value? You cannot define a stock as expensive or cheap by simply taking a look at the P/E. You must compare the P/E value to that of companies operating in the same industry. Alternatively you could compare the stock P/E to the S&P 500 index P/E. For further information on the P/E ratio please take a look at our post on “The effect of growth rate on P/E”.