Every investor is looking for the best cheap stocks to buy today. After all, it’s no secret that investing in a business while it is undervalued can reap enormous rewards, especially in the long run.
However, finding these bargain buying opportunities is not always so simple. In many cases, it can be difficult to determine whether a stock is cheap or a value trap. So, let’s explore what actually makes a stock cheap, the critical difference between price and value, and also dive into how to actually value a stock and discover buying opportunities.
What makes a stock cheap?
All too often, novice investors make the mistake of thinking that a low share price means a stock is cheap. In reality, the share price by itself does not provide enough information to make this judgement. That’s because stock prices cannot be directly compared.
Don’t forget the share price is calculated as a company’s market capitalisation divided by the total number of shares outstanding. And the latter figure is almost always different between businesses.
That’s why, despite only being a £4.4bn enterprise, Games Workshop shares currently trade at a price of around £139 (at the time of writing). Meanwhile, Lloyds Banking Group, with a market cap of £32bn, trades at a stock price of just 53p. The key difference is Lloyds has far more shares outstanding.
So, when determining whether a stock is cheap, comparing the share prices between two businesses is useless. Instead, investors need to compare the share price against the value of the underlying company.
What’s the difference between value and price?
In the stock market, the value and price of a business are not the same thing. The price of a stock is how much it costs to buy a single share of a corporation. Going back to the previous examples, the current price of Games Workshop is £139. Similarly, the current price of Lloyds is 53p.
However, the value of a stock is how much a single share is actually worth. Therefore, let’s say after crunching the numbers, an investor determines that Lloyds’ value is 45p and Games Workshop’s value is £145 a share.
By comparing the share price to this value estimate, the investor would conclude that despite trading at a much higher price, Games Workshop is actually cheap, while Lloyds is expensive. Why? Because an investor can buy Games Workshop shares at a price of £139 when they’re actually worth £145.
But the opposite could also be true. If the investor estimates the value of Games Workshop to be closer to £120, then the stock would now be expensive.
Long-term investors want to buy undervalued shares and then hold them. In the short term, stock prices can move in seemingly random directions. However, in the long run, they always eventually reflect the intrinsic value of the underlying business.
In other words, price is what an investor pays, but value is what they get.
So, the question now is, how does an investor calculate the true value of a stock when looking for the best cheap stocks to buy today?
How to calculate a stocks’ value
Valuation is a complex topic that requires a lot of nuance. That’s because determining the fair value of a business isn’t an exact science. And consequently, different investors looking at the same business could arrive at vastly different conclusions about how much each share is actually worth.
Relative valuation approach
There are a variety of methods available. Due to its simplicity, the most commonly used is known as relative valuation. This is where certain ratios that incorporate share price are calculated and compared between two or more similar companies.
The price-to-earnings (P/E) ratio is an example of a relative valuation metric. It compares a stock’s share price to the amount of earnings per share generated by the business. Essentially, it measures the cost per unit of profit from a business, where the lower the P/E, the more likely a stock is to be undervalued, especially if the ratio is lower versus its competitors.
The P/E ratio isn’t the only relative valuation metric available. And depending on the situation, alternative relative valuation metrics may be more suitable during an analysis.
Intrinsic valuation approach
A key drawback of using relative valuation metrics is it requires a similar group of companies to compare against. After all, a P/E ratio by itself doesn’t offer much information if it cannot be compared against another.
This is where estimating intrinsic value is sometimes necessary. An intrinsic valuation method uses known information about risk, growth, and the existing financials to estimate a precise share price that a firm should be worth based on a series of assumptions.
Building a discounted cash flow model is an example of calculating an intrinsic value estimate. Here, the investor forecasts the financials a business is expected to make in the future and then discounts this value back to present-day terms to arrive at a share price.
This approach has the advantage of allowing investors to incorporate a lot more information into their value estimate. Unfortunately, discounted cash flow models are also prone to the ‘garbage in, garbage out’ problem. If an investor’s forecast proves inaccurate or the wrong discount rate is used, the estimated value of a business could be wrong, leading investors into a value trap.
In other words, someone might buy shares in a business thinking it’s undervalued when, in fact, it’s grossly overvalued.
Special situations
When analysing some types of businesses, relying on classic valuation ratios and cash flow models may be unsuitable. This is particularly the case when venturing into the world of commodity-driven enterprises or financial services.
In these situations, another approach to valuation may be required. And we’ve explained the basic process in a series of guides:
- How To Value Oil & Gas Shares
- How To Value Bank Shares
- How To Value Insurance Shares
- How To Value Property Shares
Tactics for finding the cheapest stocks on the London Stock Exchange
Sadly, searching online for the best cheap stocks to buy today isn’t likely to yield any good results. That’s because thousands of other investors are doing the same. And once attractive buying opportunities are discovered they seldom last long before investors start buying, pushing the share price up and eliminating the buying opportunity.
As such, investors must explore the stock market directly themselves, sifting through companies to discover buying opportunities before everyone else does. That can take a considerable amount of time, especially for well-known enterprises which receive a lot of attention from both retail and institutional investors.
However, one tactic to improve the chances of discovering cheap shares is to deliberately explore the companies and sectors that have fallen out of fashion. By searching in areas of the stock market that most people aren’t, there is a greater chance of coming across terrific buying opportunities in the long run.