Cheap stocks can be exciting to many of us, as images of cash registers ringing echo in our heads. It's best to calmly close those cash drawers, though, because as history has shown us, many times, cheap stocks are not something to celebrate -- or buy. Here are four facts about cheap stocks every investor should know.
They can be too good to be true
When you stumble upon a seemingly cheap stock, it's easy to imagine that you've found an undiscovered treasure -- that you can snap up some shares and make substantial profits. Think again, though.
Remember how easy it is to screen for stocks these days, using the computers that most of us have at our disposal. Simple screens are available for free and financial professionals typically have access to very powerful screens. Your brokerage's website probably offers screening capabilities, too.
This means that few undiscovered gems are likely to be actually waiting for you. The thought that you have found a winner just because it has a low price is too good to be true.
They're often cheap for a reason
Cheap stocks tend to be cheap for a reason: They're not trading at rich prices because investors haven't been snapping them up. They are very likely facing some challenges -- which can be short-term or long-term in nature.
A biotechnology stock may fall to a seemingly compelling level if a key drug it has been developing posts poor results in clinical trials or is rejected by the Food and Drug Administration. A company that makes components for smartphones can seem appealing, since smartphones are big sellers, but if it loses a key contract with one of the biggest smartphone makers, its fortunes will suddenly be much less rosy.
Some low-priced companies are low-priced just because they aren't growing quickly or they've been posting losses instead of gains or maybe they're saddled with a lot of debt that they can't pay off easily.
You may be focusing on price, not value
As you find and evaluate candidates for your portfolio, be sure to not pay too much attention to a stock's price -- at least not by itself.
A $5 stock can seem like a screaming bargain next to a $100 one, but remember that a $5 pair of shoes isn't necessarily a better buy than a $100 one. A stock that has fallen to $3 per share can easily still be overvalued and likely to fall further, while a $100 stock may be undervalued and likely to rise.
If you do look at the stock's price, do so in comparison to something else, such as earnings. A stock's price divided by its trailing 12-months' earnings per share (EPS) gives you its price-to-earnings, or P/E, ratio. Once you have that, you can compare it to the company's historic average P/E over, say, the past five years -- and you can compare it to peers' P/E ratios, too.
Such examinations can yield insights into whether the stock is likely to be undervalued or overvalued.
Remember, too, that P/E ratios tend to vary by industry. Manufacturers such as carmakers that are capital intensive often have relatively low ones, while companies with lighter business models, such as e-commerce enterprises and software companies, can sport higher ones. A stock's price can also be compared with its book value, its sales, its cash flow, and so on.
As you evaluate a company, do study its financial statements, but look beyond those numbers, too, assessing its growth potential, its competitive strengths and position, and the quality of its management.
Cheap stocks can be found
Finally, know that while it's not such a simple matter to find cheap stocks that are a bargain, it can be done. Just be sure that you're thinking of "cheap" in the right way.
Cheap doesn't mean trading for a few dollars per share or having a lower stock price than another stock you're considering. A true bargain stock will be one tied to a high quality company -- one with sustainable competitive advantages such as a strong brand name and economies of scale -- that's trading at an attractive valuation. You may run across such companies in your financial reading or just in your everyday life -- such as if you notice the growing popularity of a certain product or service.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, owns no shares of any company mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.