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The following article is based on a chapter from Aswath Damodaran's book, Investment Fables.

What makes a stock cheap?

There are a multitude of things to look at when determining whether a stock is cheap: the price, market cap, earnings per share, or dividend yield. One commonly used metric is the price to earnings ratio (P/E), which allows investors to compare companies across a level playing field.

While it is not the end-all-be-all metric, the beauty behind the P/E ratio is its simplicity. Logic would argue that a stock trading at a lower P/E than its peers could be mispriced and therefore a potential value. Finding mispriced stocks is the foundational principle of value investing theory ascribed to by some of the investment greats, and there is plenty of historical data to show that low-P/E stocks outperform higher-P/E stocks over the long haul.

Another reason why low-P/E stocks can make attractive investments is that they also offer a nice alternative to bonds. Although stocks do not have coupon payments like bonds do, they do have an expected earnings yield. The earnings yield represents the expected annual return on an investor's dollar. It is simply the net earnings per share divided by the share price, or the inverse of the P/E ratio. Therefore, stocks with low P/E ratios have high earnings yields. As an example, a company that has a P/E of 12 has an earnings yield of 1/12, or 8.3%. Unlike a bond, the earnings yield is not guaranteed, since most of the money is invested back into the company and is not returned to the shareholder unless the company is paying out a very high dividend. Below are some low P/E stocks with high earnings yields.

These companies certainly look cheap, but how can we know for sure? The best way to answer this question is to break down the P/E ratio into its individual components.

As mentioned above, the P/E ratio is simply the value of a firm divided by its annual earnings. From a fundamental point of view, the value of a firm can be calculated by finding the present value of its future dividend payments. For companies that don't pay dividends, free cash flow is the next best estimate. If we assume that future dividends grow at a constant rate forever, the value of a firm can be expressed as follows:

Price = Expected Dividends per Share/ [Cost of Equity - Expected Growth Rate]

The cost of equity is simply the rate of return investors require for investing in a company at its current risk level. It is also known as the discount rate. If we divide both sides of the equation by earnings per share, we are left with a P/E ratio in terms of its fundamental value.

P/E = [Expected Dividends per Share / Earnings per Share] / [Cost of Equity - Expected Growth Rate]

Expressed this way, the equation above allows us to dissect why a low-P/E stock may not be the best investment idea. Companies with a high expected growth rate will have higher P/E ratios as the denominator goes closer to zero. Along those same lines, companies with more risk have a higher cost of equity and therefore a lower P/E ratio as the denominator increases. For these reasons, a low-P/E stock may be nothing more than an investment in a high-risk, low-growth company.

Despite the evidence that low-P/E stocks outperform their high-P/E counterparts, it's not enough to simply pick stocks with the lowest P/E ratio. It is important to look a company's risk level and growth potential along with the quality of its earnings.

Risk can be defined several different ways. Some investors define risk as the volatility with which a stock trades or its correlation with the market (commonly known as beta). Others may choose to define risk by a common metric such as an S&P ranking. For the long-term investor, the biggest risks are a company's inability to pay off debt and sustain operations during times of trouble, which can lead to bankruptcy. Some metrics that quantify this risk are the debt-to-equity and interest coverage ratios. Whatever your measure of risk is, minimizing it when investing in low-P/E stocks greatly increases your chances of success.

The second thing to bear in mind when investing in low-P/E stocks is their potential growth rate. Similar to risk, growth can be defined and estimated in a variety of different ways. One can look at the historical growth or estimates of future earnings growth. Some companies with low P/E ratios could be coming off several years of high growth but may have low future growth potential for a variety of reasons. Oftentimes, companies that trade at low P/E ratios are in mature industries with very little growth potential. Since the past is not always a good indication of the future and analysts' estimates are still only estimates, it is important to look at both historical growth and future growth potential when screening out low-P/E stocks.

The last thing to consider before investing in low-P/E stocks is the quality of a company's earnings. Valuing a stock by its P/E ratio is entirely contingent on the quality of its earnings. There are plenty of accounting tricks that can be used to overstate or understate earnings. Always be cautious of companies that consistently restate earnings or frequently take one-time charges or benefits. Also make sure there is not a large disconnect between earnings and revenue growth. A firm may be able to show a 15% growth in earnings while only producing a 5% growth in revenue, but this is a short-term phenomenon that is not sustainable.

So remember, when you see a stock trading at a low P/E ratio, don't immediately assume it's a bargain. Consider the future growth potential, the risk of the company, and the quality of its earnings before you decide whether it is the best bang for your buck.

Stocks with low P/E ratios are one type of bargain that the Inside Value team looks for. But there are plenty of others. To find out how Philip Durell is using his entire trove of value investing tools to beat the market, simply click here for your free 30-day trial.

Fool contributor Elliott Orsillo lives near the City of Angels with his wife and his basset hound, Lola. He loves a good bargain and is a sucker for the Blue Light Special. He holds no positions in any of the companies mentioned above. The Motley Fool has a disclosure policy.