The old adage for successful stock investing is to buy low and sell high. But, how do you buy cheap stocks? Where do you find them and how do you pick the most profitable ones? A couple of weeks ago we asked the question, what is value investing? Value investing should always be on your mind when searching for cheap stocks.
A simple approach to value investing is to use a stock screening tool like the one in Google Finance to find stocks with low price to earnings ratios (P/E ratio) or price to book ratios and high dividends.
In short, what you are looking for are stocks that are cheap in relation to their current market price. That is the focal point of intrinsic value analysis.
Cheap Price High Intrinsic Value
How to buy cheap stocks is to use a stock screener. A basic one can be found on Google Finance. Pick a high P/E ratio and look for stocks that have lost market price in the last year. It may be useful to do a few separate stock screens for high cap, mid cap and low cap stocks. Make a list of the stocks, their prices and P/E ratios. Stocks that have fallen in price in the last year and have higher P/E ratios should be high on your list when you buy cheap stocks. Once you have a couple of lists you will want to look at intrinsic stock value.
The key to determining intrinsic value of stock is getting a clear idea of the medium and long term prospects of the business in question. Successful stock investors learn to judge how well a company will manage its assets, products, costs, R&D, and marketing. When the picture is clear an investor can make an informed decision. If the market price is less than the intrinsic value of stock it is time to buy and if one owns the stock and the prices are reversed it is time to sell.
Here is the original formula from Benjamin Graham.
- Preceding twelve months earnings per share, EPS
- A constant of 8.5 representing an expected price to earnings ratio, P/E ratio, for a company that is not growing
- g being an estimate of long term growth (five years)
- A constant = 4.4, the average yield of high grade corporate bonds in the early 1960 decade
- Y = The current yield of AAA corporate bonds
- V = intrinsic value
The formula is as follows:
V = (EPS x (8.5 + 2g) x 4.4)/Y
Divide V by the current market price to get the relative Graham value, RGV. If the RGV is greater than 1 the stock price is cheap in relation to its expected earnings and if the RGV is less than 1 the stock is overpriced in regard to its forward looking earnings.
What If I Just Buy Cheap Stocks?
What if I just buy low priced stocks? The efficient market hypothesis says that all stocks are priced fairly according to what is currently known about the stock. As such this theory says that there are no cheap stocks in relation to market value A rule of thumb is that a randomly chosen basket of low cap stocks should include 40 stocks. For more about this approach read the book A Random Walk Down Wall Street which reports that a group of stocks chosen by throwing darts at the Wall Street Journal NYSE stock listing provided a better group of winners than most fund managers.