A share that's fallen from past highs isn't necessarily cheap. Malcolm Wheatley explains what to look for.
Every investor wants to buy shares that are cheap. Yet ironically, buying a share simply because it is cheap is one of the biggest mistakes that an investor can make.
Look no further than the bloodied banking sector, for instance, where over the past few months investors have piled into FTSE 100 stalwarts such as Lloyds Banking Group (LSE:LLOY), Royal Bank of Scotland (LSE: RBS) and Barclays (LSE: BARC) because the shares were cheap -- only to see their prices plunge still further.
The moral: "cheap in terms of past trading ranges" isn't the same as "cheap". Woeful investors in BT (LSE: BT), Aviva (LSE: AV) and Friends Provident (LSE: FP) have similar stories to tell.
But some bounce back...
On the other hand, there's ample evidence that canny investors can profit from shares that have become unexpectedly cheap. Last November, my Foolish colleague Stuart Watson wrote that shares in PC World and Currys owner DSG International (LSE: DSGI) "could prove to be absolute steal," and that "there was massive upside potential."
The shares were then 14p, having dipped below 10p the previous week, a far cry from the level of 170p two years ago. But last Thursday, before the Easter holiday, they closed at 30p -- more than doubling in four months, even as the FTSE 100 has fallen 7% over the same period.
Housebuilder Taylor Wimpey (LSE:TW) is another example. Last Thursday its shares closed at 43p, well down from the level of 165p that they were a year ago. But in the meantime, they've been as low as 4p, which is what they had slumped to by late last November. That's right: 4 pence. A £1,000 punt on Taylor Wimpey back then would have grown tenfold.
You're buying a company, not a share price
The trick to deciding whether a share is cheap, then, involves much more than simply looking at its price. Never forget, you're buying a company, not just a share -- and with that company, you're getting its management, its debts, its pension obligations, its balance sheet and its business model.
Benjamin Graham, one of the great all-time investors, and the author of The Intelligent Investor, suggested evaluating a company on five key elements:
- The company's general long term prospects
- The quality of its management
- Its financial strength and capital structure
- Its dividend record
- Its current dividend level, or yield.
How the Fool can help
There's a wealth of information here on the Fool to help you evaluate those things -- and more. The financial lowdown on the company, for instance, is contained in the "fundamentals" page. Type in the company's ticker code, (after looking it up if you don't already know it), and see the last five years' financial results, as well as critical metrics such as the yield and PE ratio. For example, here's the financial lowdown on oil giant Royal Dutch Shell (LSE: RDSB).
Baffled by some of the terminology and figures? We have an introductory guide which you can find clicking on "Investing Basics" on the "News and Analysis" tab on the web site.
And what about the non-financial aspects of a company? Its business model, strategy and management? A good place to start, in many cases, is that company's discussion board, here on the Fool. Here's the discussion board for Royal Bank of Scotland, for example.
In this market, there are real bargains to be had. And armed with the right resources, you can track them down. Don't forget that once you've found your bargain share you can buy it using The Motley Fool Share Dealing service. Real-time trades cost just £10 and you can also use Sharebuilder to set up a regular purchase plan for just £1.50 per trade. It's free to open an account.
Of the companies mentioned, Malcolm Wheatley owns shares in Lloyds Banking Group and BT.
