Buying cheap stocks is not the same as value investing – it pays to know the difference

There are many different types of investors: some focus on growth stocks, while others prefer dividend-paying stocks, and some look for value.

Value investors look for stocks trading below their intrinsic (or true) value. By finding companies whose stock price does not reflect their business or financials (such as revenue and earnings), value investors hope to profit from the broader market undervaluing certain stocks. In other words, if a company’s true value is $100 per share and it’s trading at $80, value investors will invest, hoping that eventually the market will correctly value it at $100 and they’ll make money (25% profit).

Investors should be careful not to confuse a cheap stock with a value stock because this can be expensive. It could be that a $1,000 stock is undervalued and a $3 stock is overvalued. You always want to avoid the value trap, which is a stock that looks cheap but isn’t. You’ll regret buying a lot of stocks because they’re cheap, only to find yourself investing in a failing or stagnant business.

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Using the P/E ratio to find undervalued stocks

A great way to determine whether a stock is under- or overvalued is by looking at the price-to-earnings (P/E) ratio, which tells you how much you’re paying for every dollar of the company’s earnings. You can find a company’s P/E ratio by dividing its current stock price by its earnings per share (EPS). For example, if a stock is $100 and has an EPS of $4, the P/E ratio will be 25, meaning you pay $25 for every $1 in earnings.

You can’t look at the P/E ratio alone to determine if a stock is undervalued; you should compare it to similar companies in its industry. You wouldn’t compare An apple (AAPL -0.14%) to ExxonMobil (XOM 1.45%) or Bank of America (BAC 1.68%) to Tesla (TSLA -6.63%)but you can compare apple with Alphabet (GOOGL -0.61%) (GOOG -0.55%) or Bank of America to Wells Fargo (WFC 2.31%).

If you’re looking at a company’s P/E ratio and it’s noticeably lower than other companies in its industry, that could be a sign that it’s undervalued. The reverse is also true. If a company’s P/E ratio is in the 20s while others in its industry are in the single digits, it is likely overvalued.

Finding value stocks is not that easy

You’d be hard-pressed to find someone who doesn’t like a good discount—it’s what makes value investing attractive to many people. But if value investing were simple, everyone would be finding value stocks and making good investments. Unfortunately, this is not the case.

Value investing takes time and research. After all, you don’t know if a stock is undervalued just by looking at its price; you need to research the company itself as well as compare it to similar businesses to make this decision.

Value investing is a great way to minimize some of your risk and increase your chances of good returns, but it takes time to become a good value investor. If you’re willing to put in the effort, it can pay off handsomely.

Bank of America is an advertising partner of The Ascent, a Motley Fool company. Wells Fargo is an advertising partner of The Ascent, a Motley Fool company. Suzanne Frey, CEO of Alphabet, is a member of The Motley Fool’s board of directors. Stephon Walters holds positions in Apple. The Motley Fool has positions in and recommends Alphabet (A Share), Alphabet (C Share), Apple and Tesla. The Motley Fool recommends the following options: long March 2023 $120 Apple calls and short March 2023 $130 Apple calls. The Motley Fool has a disclosure policy.

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