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When we talk about cheap stocks, we're not talking about stock price. Some people think Apple's stocks are cheap, even though, at the time of publication, one stock costs about $600.
You have to look at valuations, or metrics, to determine whether a company is cheap or not. You want to buy a business with low valuations in the hopes that those numbers will grow over time. If they grow, the stock price will rise.
You can look at numerous metrics, but here are a few valuations to start with:
1. Price-to-earnings ratioâ€¨
This is one of the most important numbers to look at. The calculation is based on the company's share price compared to its per share earnings, so basically it's about how much investors are willing to pay for each dollar of a company's earnings.
A low price-to-earnings (PE) ratio usually means a company is cheap; a high one means it's expensive. How high is too high depends on the industry and the other companies in that sector. A good way to look at it though is what's the PE compared to the average PE of an index, such as the S&P 500. That index's PE is around 14.5 times earning today -- anything less could be considered cheap.
Price-to-book, or PB, is another common valuation that financial experts consider. To get the number, you divide the share price by the book value. Book value is the total value of a company's assets -- the total assets minus liabilities. (You can find this information in annual reports or by reading analyst reports.)
This metric tells you how much you're paying for the company's assets. Like with PE, the lower the PB, the cheaper the company. Most fund managers like companies with book values around one or below, though it depends on the sector.
3. Debt ratio
â€¨The less debt a company has, the better shape it's in. So look at the debt ratio, which is total debt divided by total assets. If the number is more than one, then the company has more debt than assets. If it's less than one, it has more assets than debt. In most cases, portfolio managers like companies with debt ratios below one. They're often in a better position to withstand a financial setback.
But higher debt isn't necessarily bad, especially if the company is borrowing money to buy other companies, which will ultimately help it make more cash. Look at the debt ratio and then do some homework to find out why it's high or low.
4. Free cash flowâ€¨
Every investor wants the businesses they own to make money and the more the better. This metric tells people just how much cash the company is raking in. It's operating cash flow, minus expenditures; in other words, it shows how much the company is making after spending the money it would take to maintain and expand its business. The number is often presented as a percentage of total cash flow. Typically, a high number indicates it's got a lot of excess money.
It's important not to look at these metrics in isolation. If a PE ratio is low, find out why. Does a particular company have a lot of debt? Is it generating cash? If not, then maybe it's low because the business is in trouble. If, say, its free cash flow is high, then maybe the company is in good shape, but another company in the sector is in trouble and it's dragging everyone down.
To find these numbers, read through annual reports and analyst notes. Also look at sites like Google Finance or YCharts. Once you understand what you're looking for, you too can pick stock like the pros.