In the pandemic-inspired days of Robinhood stock slinging, we're often tempted to buy company shares that may have crashed recently or simply have a low price. Buying cheap stocks doesn't necessarily mean buying valuable stocks, and buying a stock at its low is no guarantee that you've made a good deal. While buying a stock when its valuation has fallen may be an important component of a sound investing strategy, there are many additional aspects that need to be considered before investing money.
What does "cheap" even mean?
In examining one definition of the term, "cheap stock" can simply mean a stock with a low share price. Stocks with prices under five dollars are otherwise known as "penny stocks." These super-cheap shares are often more volatile, less frequently traded, and more difficult to evaluate than those of more established enterprises. Stocks with slightly higher prices, in the $5 to $30 range, are still relatively "cheap" compared to the Berkshire Hathaways (NYSE: BRK.A) of the world -- but we'll soon learn that stock price alone is not determinant in a buying decision.
From another angle, a stock can feel cheap after it has crashed or lost a significant amount of value in the recent past. If a stock goes from $100 to $20, you might feel as though it's a good time to buy. As with most questions in life, the answer is: Maybe. Simply because a stock has recently crashed leaves no information about its future performance. As humans, we tend to be anchored to the possibility the stock will return to its previous highs.
Finally, a stock with a low price-to-earnings ratio (or "P/E" ratio) can also be considered "cheap." This ratio is generally valuable as a component of fundamental analysis, but not always. The ratio simply takes the stock's current market price and puts it over the company's annual earnings per share. Stocks with a higher P/E are considered to be on the expensive side, as you're literally paying a higher price relative to the profits a company generates. Stocks with low P/E ratios, comparatively speaking, are generally considered to be cheap.
The P/E ratio, importantly, is fallible. The ratio can be utilized as a simple tool to evaluate a company's price, but the ratio ignores growth prospects and debt, can rely on projections, and is really only valuable when compared to the same ratio for industry competitors. All else equal, the P/E ratio should simply be seen as one bellwether of many in deciding whether to buy a stock. Use the ratio, but proceed with caution.
Image source: Getty Images.
How to evaluate stocks
Reality suggests that we need to consider the current factors impacting the stock -- primarily, those that affect the company's ability to generate future earnings -- before deciding to buy it. These include the competitive business environment in which the company operates, the company's financial leverage (its debt), and the company's management team.
This thorough evaluation forms the basis of fundamental analysis, which involves examining the company's underlying financials to determine a fair price for its stock. Once a fair price has been determined, you can compare that price to the stock's current market price to determine if it is overvalued or undervalued.
Consider the broad market indices
Given the risks of buying stocks simply based on their price, you may want to avoid buying single stocks altogether. Markets have become informationally efficient. This means that the current stock price you see in the market is a near-perfect reflection of all publicly available information. There isn't a ton of room to exploit mispricing in a market that incorporates new information and adjusts instantaneously.
If you choose to accept this premise, you might consider investing in a broad market index mutual fund that mimics the broader market -- namely, an S&P 500 fund or a Russell 2000 fund. This allows you to ignore the laborious work of stock analysis and enjoy market returns at a very low cost, all while avoiding single company risk. For investors who prefer a low-touch minimalist approach, this is a viable option.
Be careful when buying cheap stocks
When you're about to buy a stock, you're buying business earnings. The price you pay may or may not be an accurate reflection of the company's ability to produce those earnings in the future. While a low price can certainly be a component of a smart stock purchase, it needs to be taken in totality along with the company's wider financial picture -- especially compared to its peers. For the lay investor, rather than buying cheap stocks, it's definitely worth considering diversified index funds and letting time do the work.
