Buying cheap stocks isn’t 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 stocks, and still others seek value.

Value investors look for stocks that are trading at a price lower than their intrinsic (or true) value. By finding companies whose stock price doesn’t reflect their business or financials (like sales and earnings), value investors hope to capitalize on the broader market’s undervaluation of certain stocks. In other words, if a company’s true value is $100 per share and it’s trading at $80, value investors invest hoping that the market will eventually price it correctly at $100 and get their money earn (a 25% gain).

Investors need to be careful not to confuse a cheap stock with a value stock, as doing so could be costly. It could well be that a $1,000 stock is undervalued and a $3 stock is overpriced. You always want to avoid a value trap, which is a stock that appears cheap but isn’t. You’d regret buying lots of stocks because they’re cheap, only to find out you’re investing in a failing or stagnant company.

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Use P/E to find undervalued stocks

A good way to tell if a stock is undervalued or overvalued is 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 by dividing its current stock price by its earnings per share (EPS). For example, if a stock costs $100 and has EPS of $4, its P/E would be 25, meaning you pay $25 for every $1 of profit.

You can’t look at price-to-earnings multiples alone to determine if a stock is undervalued; You have to compare it to similar companies in its industry. You wouldn’t compare Apple (AAPL -0.14%) to Exxon Mobile (XOM 1.45%) or Bank of America (BAC 1.68%) to Tesla (TSLA -6.63%)but you could compare Apple to it alphabet (GOOGL -0.61%) (WELL -0.55%) or Bank of America Wells Fargo (WFC 2.31%).

If you look at a company’s P/E ratio and it’s significantly lower than other companies in its industry, it could be a sign that it’s undervalued. The opposite 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’s likely overvalued.

Finding value stocks isn’t that easy

It would be hard to find someone who wouldn’t like a good discount — that’s what makes value investing appealing to a lot of people. But if value investing were easy, everyone would find value stocks and make 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 yourself and compare it to similar companies to make that decision.

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

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, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Stefon Walters has positions at Apple. The Motley Fool has positions in and recommends Alphabet (A shares), Alphabet (C shares), Apple, and Tesla. The Motley Fool recommends the following options: long March 2023 $120 calls on Apple and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.

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