How to tell when a stock is cheap or expensive

 

You want to invest in the stock. but have no idea whether or not now is a good time to buy. Sure you've heard the age-old buy low sell high, but what does that really mean. When does the stock's price considered low $10 a share? $100,? there's no perfect answer to these questions. But there are ways to at least gauge how expensive or cheap stock is.

 You see by using something called a multiple, we can figure out how much we're paying for stocks underlying business. And if this price has changed over time. interested? Let's dive into the topic. 

You may have noticed that when you google search a stock like: well Google for example. You end up with a series of search results as well as some basic details about the ticker. In there you have your stockys open price, market capitalization and dividend yield but also lists something called the p/e ratio of the company. 

The p/e is an example of what's called a multiple ratio, that compares a stock's price to some fundamental number. Generally speaking the higher the multiple, the more expensive a stock is considered. Think that as like a price per pound at a butcher shop. In shopping for pork, beef or chicken, it's difficult to compare the total prices, since the quantity you get is different for each cut. But if you look at the price per pound, you can easily figure out which cut is the best bang for your buck.

 Multiples work in a similar way allowing us to compare the price of a stock to the underlying fundamentals you get with the purchase. Now there are hundreds of different multiples that investors can use including the evie to ebita, price to book value, big setter, etcetera. Some of the multiples are industry specific. whereas, others are more broad in nature and each carries a different implication. But the p/e ratio which stands for the price to earnings ratio is one of the most straightforward and popular.

 It's easy enough to calculate since you take the stock's price and divide it by the company's earnings per share. for example if company A had 1 million shares outstanding, each of which we're trading out of price of $30, and last year their net income was 2 million dollars, the stock's p/e ratio would be 15 times. This p/e ratio is known as a trailing p/e because we're calculating it using historical information. And it's one of the easiest multiples to understand. It basically represents how much an investor is willing to pay per dollar of company's profits. So for company A, we are paying a price equal to 15 times our share of the company's profit.

So the trailing p/e helps conceptualize how much we're paying for a stock. But it does have its shortcomings. The biggest one being that it is backwards looking whereas, many believe that markets are forward-looking. If a company is expected to release a new product, enter a new market or improve its operations in the future, then a stock will likely trade higher. something that the trail p/e wouldn't take into account. Using past earnings to explain this Stocks current price. Because of this many investors prefer instead to use what's known as a forward multiple.

 In this case the forward p/e which divides a stock's price by how much the company is expected to make next year. For example let's say that company A is expected to launch a new bagel product next year, and as a result analysts are expecting earnings to increase to 2.5 million dollars next year. In this case assuming everything else remains unchanged company A's forward p/e multiple would equal 12 times. Now the clear problem with for multiples is that they rely on forecasts which may not pan out. But they can still help gauge the value of a stock and how much investors are paying up for a company's potential profit. So for a play megacode our forward looking p/e is 12 times. great! but what does that mean? Well by itself not a whole lot.

 You see multiples are relative measure. sure understanding how long it will take for your stock to pay for itself is useful. But to understand whether the level is attractive or not, we've got to compare it to other multiples. we could for example compare the p/e ratio to company A's historical p/e ratios to see how it has changed over time. This will give us an idea of whether investors are valuing the company higher, lower, than normal. If the company's earnings are expected to increase but the price of the stock has fallen, it would mean that the multiple has contracted and investors don't value the profitability of the firm as much as they used to. Alternatively, if earnings are falling but the prices risen, well the multiple has expanded meaning people are paying more for less profit.

we could also compare the p/e multiple to the stock's long-term average to see whether the margin is larger or smaller than normal. If the stocks ten-year average p/e is 15 times for example. We can assume that the stock's multiple is temporarily cheaper than normal and may want to buy. If we pick up the stock in the multiple later expands back to its long term average then we could earn a return even if that company's earnings are flat.

 A key assumption here is that a multiple is expected to revert to its mean over time and while that doesn't always hold true, investors sometimes look for extreme variations from the mean with many believing that short-term volatility in the stock small which could be caused by a bad press release or negative near-term headwind, will eventually subside causing the multiple to return to its normal level. Assuming a company's core business remains unchanged.

 Awesome so if I find a company that's trading out of multiple below its historical average I'm good to buy. right? well not quite. sure understanding where the company's stock value stands relative to its past is great. But you need to compare the value to other stocks as well in the same industry.

 In our analogy if you found pork on sale for $6 a pound, they may still be too expensive if a butcher down the road, is offering pork for a regular price of $2.50 a pound. Similarly if we need to gauge the value of a stock relative to its peers so let's take company A and compare to company B and the company C which are trading at for PE s of 13 times and 7 times respectively if you compare company A's 12 times multiple to its pier average of 10 times well then we can see that the stock is actually more expensive than other companies on average. 

All right, so the stock is cheaper than it normally is but more expensive than its peers. So should I buy or sell or what. Well as great as it would be to have a one number basis for making investment decisions, it's simply not that simple. Multiples are limited in the amount of insight they provide. With a p/e multiple for example, we are taking into account the company's growth rate. Sure compared to peers company A's p/e of 12 times may seem expensive, but a company A  is also growing its earnings at a faster pace. The multiple may be justified. This is why high growth companies like those in the tech space tend to have higher multiples than stocks and slower moving areas like utilities. On the other side of the spectrum, just because a company is trading at a p/e below its peers or even below its historical average doesn't mean it's a good buy. The multiple compression could be justified if the company's fundamentals have deteriorated.

 what do I mean by that? Well let's go back to our analogy. Imagine you're at the butcher shop and you see two steaks trading at $10 a pound and $3 a pound, looking for some value you pick up the $3 cut. But when you get home you find that the steak you bought has expired and that it's a lower quality cut. you're not even sure if it's actually a beef anymore. So aside from learning that there's probably something wrong with three dollar steak, what's the lesson here? 

well just because something is cheap doesn't mean you should buy it. A lower stocks p/e may reflect a justified devaluation of the company maybe for the company A's bagel co keto diets are expected to kill the bagel industry or maybe the companies facing regulation that will prevent it from making its staple bagel. These are things that would hurt company A's future profitability. And even though the multiple would contract, it doesn't make the company a good buy. because the company's core long term prospects have deteriorated. That's the thing about multiples. they are pretty meaningless without context and chasing low multiples without an understanding of a company's core business and future prospects may leave you in to something called a value trap. A stock that looks cheap compared to its historical crisis, but continues to fall even further because of a deterioration in the firm's fundamentals.

 So why discuss multiples if they could mean that a stock is both over and undervalued? Well it's not that multiples are useless. They are a handy way to quickly understand a stock's price level but as I said at the beginning, they are a rough gauge of a stock's value at best. Some investors even contest that the p/e multiple is incredibly limited, because of its use of accounting earnings numbers which may be easily altered by management assumptions and non-cash items.

 So while multiples can certainly help you make investment decisions, we need to ensure that your decision itself is based on a thorough understanding of a firm's operations and its future prospects. not just the stocks multiple. A good approach is to find companies you like based on their fundamentals and then find some appropriate multiple to understand the firm's valuation. After the fact looking for cheap stocks first mainly, be with a portfolio of low quality holdings. After all as warren buffett says it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. 

So next time you find a stock trading at a low multiple or a stake selling at three dollars a pound make sure to check the fundamentals and the stakes expiration and that the steak is actually steak.

Thanks so much for reading. Hope you found value in this post. Let me know in the comments below.