How to Find Good Shares Cheap

There's much more to cheap shares than a low P/E ratio.

The following article is based on a chapter from Aswath Damodaran's book 'Investment Fables'.

What makes a share cheap?

There are many things to look at when determining whether a stock is cheap: the price, market cap, earnings per share, or dividend yield. One commonly used metric is the price to earnings ratio (P/E), which allows investors to compare companies across a level playing field.

Keeping it simple

While it is not the end-all-be-all metric, the beauty behind the P/E ratio is its simplicity. Logic would argue that a share trading at a lower P/E than its peers could be mispriced and therefore a potential value stock. Finding mispriced stocks is a fundamental principle of value investing, and there is plenty of evidence that low-P/E stocks outperform higher-P/E shares over the long haul.

Another reason why low-P/E stocks can make attractive investments is that they offer a nice alternative to gilts and bonds. Although shares do not have coupon payments like bonds do, they do have an expected earnings yield. It is simply the net earnings per share divided by the share price, or the inverse of the P/E ratio.

Therefore, shares with low P/E ratios have high earnings yields. As an example, a company that has a P/E of 12 has an earnings yield of 1/12, or 8.3%.

Measuring value

Unlike a gilt or bond, though, the earnings yield is not guaranteed. The only way for investors to cash in on earnings is when companies pay them out through dividends. Below are some low P/E shares with their corresponding earnings and dividend yields.

These companies certainly look quite cheap, but how can we know for sure? The best way to answer this question is to break down the P/E ratio into its individual components.

Running the numbers

As mentioned above, the P/E ratio is simply the value of a company divided by its annual earnings. Using the dividend discount model of valuation, the value of a company can be calculated by finding the current value of its future dividend payments.

For companies that don't pay dividends, free cash flow is the next-best estimate. If we assume that future dividends grow at a constant rate forever, the value of a company can be expressed as follows:

Price = Expected Dividends per Share / (Cost of Equity - Expected Growth Rate)

The cost of equity is simply the return investors require for investing in a particular company. If we divide both sides of the equation by earnings per share, we get

P/E = (Expected Dividends per Share / Earnings per Share) / (Cost of Equity - Expected Growth Rate)

Expressed this way, the equation above allows us to dissect why a low-P/E share may not be the best investment idea. 

Companies with a high expected growth rate will have higher P/E ratios as the denominator goes closer to zero. Along those same lines, companies with more risk have a higher cost of equity and therefore a lower P/E ratio as the denominator increases. 

For these reasons, a low-P/E share may be nothing more than an investment in a high-risk, low-growth company.

Incorporating other factors

Despite the evidence that low-P/E shares outperform their high-P/E counterparts, it's not enough to simply pick shares with the lowest P/E ratio. It is important to look at a company's risk and growth potential along with the quality of its earnings.

Risk can be defined several ways. Some investors use beta to measure risk, while others use share rankings. For the long-term investor, the biggest risks are a company's inability to pay off debt and sustain operations during times of trouble, which can lead to bankruptcy. Some metrics that quantify this risk are the debt to equity and interest coverage ratios. Whatever your measure of risk is, minimising it when investing in low-P/E shares greatly increases your chances of success.

The second thing to bear in mind when investing in low-P/E stocks is their potential growth rate. One can look at the historical growth or estimates of future earnings growth. Some companies with low P/E ratios could be coming off several years of high growth but may have low growth potential for a variety of reasons.

Often companies that trade at low P/E ratios are in mature industries with very little growth potential. Because the past is not always a good indication of the future, and analysts' estimates are still only estimates, it is important to look at both historical growth and future growth potential when screening out low-P/E stocks.

Finally, realise that there are plenty of accounting tricks that can be used to overstate or understate earnings. Always be cautious of companies that consistently restate earnings or frequently take one-time charges or benefits. Also make sure there is not a large disconnect between earnings and revenue growth. A company may be able to show a 15% growth in earnings while only producing a 5% growth in revenue, but this is a short-term phenomenon that is not sustainable.

Get real value

So remember, when you see a stock trading at a low P/E ratio, don't immediately assume it's a bargain. Consider the growth potential, the risk of the company, and the quality of its earnings before you decide whether it is the best bang for your buck.

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> This article was originally written by Elliott Orsillo, and first published on Fool.com. It has been updated, most recently by Bruce Jackson.