Value investing is one of the most intuitively appealing investment methods out there, and the reason is simple: Everyone loves a bargain. But just like smart shoppers ask tough questions about product quality before they jump on a sale-priced item, so too do value investors have to look closely at beaten-down stocks to decide whether they’re truly good values or just cast-off clearance-rack companies with few future prospects.
The dangers of cheap stocks
If value investing were as simple as finding stocks trading at cheap prices, then it would be a trivial endeavor to make money. Even most beginning investors understand that low share prices by themselves mean nothing, as the total value of a company depends not only on the price per share of stock but also on the number of shares outstanding. A company with 1 million shares priced at $100 is worth the same as one with 100 million shares priced at $1, so gauging whether a stock is expensive or cheap based solely on share price doesn’t give you enough information to draw valid conclusions.
Yet while most investors know to go beyond share price, they often get stuck at the earnings-multiple stage. The ratio of price to earnings is one of the favorites in all of value investing, as it attempts to tie the fundamental driver of stock prices to the prevailing current share price in the market. In general, the more net income a company is able to generate, the more valuable its shares should be.
Before you conclude that a stock is fundamentally cheap based on its P/E ratio, though, you need to look not just at its current earnings but also at its future prospects. Often, especially with cyclical stocks, you’ll find that P/E gives you the exact opposite message that you’d expect. Consider these examples:
- In the energy sector, oil giants
Exxon Mobil Corporation (NYSE:XOM) and Chevron Corporation (NYSE:CVX) both have attractive P/E ratios of around 10. Yet looking forward, analysts don’t expect either company to produce a lot of profit growth, as both companies have had to work extremely hard to avoid massive output declines stemming from falling production levels from their respective oil-field assets. As long as Exxon Mobil Corporation (NYSE:XOM) and Chevron Corporation (NYSE:CVX) can acquire new properties with lucrative prospects, they’ll be able to keep revenue up, but it’s far from certain whether they’ll succeed in finding new discoveries.