How do I know if cheap stocks are really cheap?

So many investors think of a company’s share price like a price tag – I can’t afford that $100 stock, the thinking goes, so I’m going to sort through the bargain bin. Maybe something under $5.

But stocks aren’t sunglasses.

And a low share price might have nothing to do with the value of a stock — a 25-cent stock can be way overpriced if there’s no real business behind it, and a $100 stock can be an absolute steal if it’s on its way to $500.

So how do you know if cheap stocks are really cheap?

The story of value

Amgen (Nasdaq: AMGN) is a remarkable success story. Five-plus years after its IPO, Amgen was still a tiny company that had not yet scratched the surface of its potential. On Jan. 2, 1990, Amgen traded for $1.07. Twenty-five years down the road, it trades for more than $150.

That gain illustrates the profit potential of investing in promising small companies. It also goes to show that if you want Amgen-like gains, you need to look for stocks trading around $1 per share — or definitely below $5. Just take a look at this list of winners since 1990 and their stock price back then:

Company Stock price
on Jan. 2, 1990
Microsoft (Nasdaq: MSFT) $0.53
Oracle (Nasdaq: ORCL) $0.60
Target (NYSE: TGT) $4.30
Pulte Homes (NYSE: PHM) $1.22

Say it with us: No, no, no!

Here’s where we pull back the curtain: All of those Jan. 2, 1990, prices are adjusted for stock splits and — in some cases — dividends. While Amgen was a tiny company back in 1990, it still traded for $51 per share. Microsoft traded for $88, Oracle for $24, Target for $64, and Pulte Homes for $11.

So we hope we’ve done a little bit of myth-busting here. Namely:

  1. Lower-priced stocks don’t go up any faster than higher-priced stocks.
  2. Lower-priced stocks aren’t necessarily cheaper than higher-priced stocks.
  3. Lower-priced stocks aren’t necessarily smaller than higher-priced stocks.

By itself, a stock’s price can’t tell you anything about the value of the underlying company or its investment potential.

Great companies focus on allocating capital efficiently and growing the business for the long term. If the business is succeeding, the stock will follow — regardless of whether it’s starting from $5, $50, or $500.

Just look for key traits of the market’s biggest successes:

  1. Cheap valuations relative to a company’s earnings or cash flows.
  2. Tenured managers who own a significant number of shares.
  3. Growing operations in a profitable niche.

If you’d like some help finding companies that meet these criteria, our team of analysts at Stock Advisor work tirelessly to uncover them for our members. We’ve set up a free 7-day trial to our flagship investing service so you can take a look.

Because a great company is worth finding … no matter the stock price.

— Answer provided by Fools Tim Hanson and Brian Richards

Related Articles