WARNING: Cheap Stocks ARE NOT Value Stocks!

Do you like the idea of investing in cheap stocks — for example, stocks that trade for less than $5, or less than $2, or mere pennies?

These stocks are indeed cheap in dollars. However, they are not necessarily cheap in terms of value. Often, they’re actually expensive from a valuation perspective.

One of the most common mistakes investors make is thinking that a low price makes a stock a bargain. That’s not the case at all. A stock is undervalued if the future value of all of its earnings and assets is greater than its stock price. As you’re about to learn, a stock that trades for $0.000001 can be extremely overpriced, while a stock trading for $1 million can be cheap!

The difference between cheap and undervalued

Many value investors use the terms “cheap” and “undervalued” interchangeably. However, when they say “cheap,” they don’t mean what you might think it means. “Cheap,” for a value investor, means that the stock is inexpensive compared to what the underlying fraction of the business earns.

If a stock costs $1 million, and each share brings in $10 million a year in earnings, it’s undervalued. If a stock costs $0.000001 and brings in no revenue, it’s expensive. It’s the ratio of price to underlying value that gives you the valuation, not the price of a share in dollars.

An example

To illustrate how undervalued stocks can be expensive in dollars (and vice versa), we can look at Suncor Energy (TSX:SU)(NYSE:SU). At $41.80, it’s far from the cheapest stock out there. It won’t break the bank to buy just one share, but if you’re living paycheque to paycheque, you might have a hard time coming up with the money to buy multiple shares of Suncor.

However, the stock is not expensive from a valuation perspective. That is to say, its price is not high compared to what the underlying fraction of Suncor Energy earns in profit. Using Suncor’s last 12-month financial results, we can calculate that its stock trades at

  • 6.6 times earnings;
  • 1.42 times book value (book value means assets minus liabilities);
  • 1.16 times sales; and
  • 3.8 times cash flows.

In other words, Suncor Energy earns enough cash flows to buy all of its shares back in 3.8 years at today’s prices. That suggests that it is an undervalued stock.

Foolish takeaway

It’s natural to want to buy cheap stocks. Certainly, it’s better to buy low than to buy high. But when you go searching for stocks, you should think about what the word low really means. Any company can make its stock price low by doing a stock split (i.e., dividing one share into multiple shares). In and of itself, stock price means nothing. It’s the stock price compared to the value of the underlying business ownership position that matters.

As I showed earlier, a stock can be cheap at $1 million and expensive at $0.000001. In the world of valuation, the amount of money needed to buy a share is irrelevant. What counts is the amount of value you get when you buy the share.

The post WARNING: Cheap Stocks ARE NOT Value Stocks! appeared first on The Motley Fool Canada.

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Fool contributor Andrew Button has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.