Why you need the right lens to spot a cheap share
By: Tim Bennett


With the stock market down around 30% from its peak only a few weeks ago, investors will be wondering whether this is the right time to buy. However, to identify a cheap stock that will form part of a long-term portfolio you need to apply the right filter. Here is a short tour of some of the most popular ones.

A recap

Value investors (which, by definition, anyone looking for a bargain tends to be), need a way of comparing one stock to its peers group and the wider market. Enter the price ratio. This offers a way of comparing the current share price to another indicator, or growth driver – the higher the result the more expensive the share and vice versa in very broad terms. The question then becomes, what should an investor compare the share price to?

Price to sales ratio (PSR)

An alternative to the P/E, this compares the latest share price to the sales (or revenue) number per share. It is useful for firms that may have small, or even negative, earnings and is widely used in business valuation exercises. However, an obvious flaw is that it only looks at the sale number and completely ignores whether a firm is profitable, let alone cash generative.
Naturally, it falls down for many “new” economy firms in, say, the technology sector because they simply will not have much of a “book” to value.

Price to cash flow

For some analysts, this is the pick of the crop in so far as it looks at the number that many consider to be “king”. Cash is much harder to manipulate than profits or sales. However, it is also volatile in many firms and often non-existent in those early stage firms that are focused on growth.

Price to earnings growth (PEG)

Favoured by Jim Cramer of CNBC and Fox fame amongst others, this equate the share price to a firm’s earnings growth rate. So, very simply, if a firm’s P/E ratio is 10 and its earnings growth rate estimated at 20%, the PEG is 0.5. The lower the better with a result below one considered a bargain. The problem with this ratio, however, is twofold – earnings growth rates are often big estimates and finding firms where the result is under 1 can be a challenge.

Price to EDITDA

The final ratio on the list compares price to adjusted profit, expressed as profit before interest, tax, depreciation and amortisation. Favoured by heavily indebted, capital-intensive sectors, it nonetheless falls down if these costs are only being removed from a profit number to flatter the directors.
The bottom line is that finding the right lens with which to view a share can be tricky. If you would like to discuss this further, please contact an Adviser or email me at the usual place.