Everyone loves a deal but often investors fall into the trap of an emotional buy, “that low-priced stock is a bargain, and I should buy it.” A five-dollar stock that moves to $10 is a 100% gain it doubles your money; that feels like a win-win, right? Unfortunately, it’s an emotional way of buying stocks. A rational analysis would be that a low-priced stock is not usually a “cheap” stock but may actually be fairly valued or even overvalued.
Take a look at Sirius XM Holdings, Inc. (symbol SIRI). It recently traded at $5.24 per share (on May 30, 2017). This would certainly be considered a low-priced stock. With a small investment outlay you can buy a lot of shares in the company. But looking at the underlying fundamentals tells a different story on the stock’s valuation. The trailing P/E (price to earnings) ratio is 32.78 and the forward P/E ratio based on projected earnings over the next 12 months is 24.68. The revenue growth rate has been 7.70% over the past year. It’s an “okay” revenue growth rate, but not fantastic. The book value per share is -.20, which suggests that the company has higher liabilities than assets and owners’ equity. The current trailing P/E ratio for the S&P 500 Index is 18.77 and the forward P/E is 16.54. Comparing the P/E ratios of Sirius to the market as a whole illustrates how expensive Sirius is relative to the market.
Another company to review is Advanced Micro Devices (symbol AMD). It has a current share price of $11.00. It has a trailing P/E of -20.83 suggesting negative earnings over the past 12 months. Its forward P/E is 37.10, again suggesting a pretty lofty valuation. Its book value per share is 43 cents. Again, relative to the S&P 500 Index, AMD may be very expensive.
In contrast, if we look at the fundamentals of a company such as Apple (symbol AAPL) we see a different valuation. Apple sells for $153.90 per share, which most would consider a high-priced stock. It has a trailing P/E ratio of 18.05 and a forward P/E ratio of 14.61. Relative to the market as a whole, Apple may be a little undervalued at this time.
One other example worth reviewing is the stock of Alphabet (symbol GOOG), which is formerly Google. Its current share price is $975.90. It has a trailing P/E ratio of 32.98 and a forward P/E ratio of 24.13. Its P/E ratios are very similar to those of Sirius XM Holdings. This is certainly a high-priced stock, which may also be a very expensive stock. Compared to the market as a whole, it is expensive. Investors may be placing a higher multiple on Alphabet because they believe that earnings will grow faster than the overall earnings for the market. With those expectations, a higher multiple may be justified.
Earnings surprises can occur and what may look like a reasonable expectation for future earnings can fall short making current valuations expensive in hindsight. Caution is in order when simply looking at relative valuation metrics going forward. However, by looking at fundamentals one can put the actual price a stock is trading at into perspective.
When buying a stock, investors are better served by evaluating a company’s real value rather than emotionally buying what appears to be a bargain. A stock may be low priced for a reason. A stock’s current price is a reflection of the underlying company’s future earnings potential and expected growth of those earnings. One needs to ignore an arbitrary price level and understand if the current price fully reflects the company’s true value.
POSTSLower Your Taxes on Investments by 50% or More