Buying cheap and selling expensive is the goal of every stock investor. The old buy low, sell high mantra is one that every successful investor religiously follows. However, many investors are confused or uncertain about what exactly the word cheap means in the stock market.
Recently, CNBC ran an article outlining the seven cheapest stocks in the S&P 500. The piece sparked my interest in determining exactly what cheap means when it comes to stock prices. Once it is understood what cheap means, in terms of share price, this actionable information can be applied to locate profitable stocks for investment.
The first thing to keep in mind is the way most successful investors use the terms cheap or expensive is relative. I am not talking about relative to past prices of the same company but rather relative to other stocks in the same sector or market index.
Locating these stocks that are “For Sale” is the goal of the successful investor.
While a stock can be cheap or expensive relative to its own price history and this information can be important to know, this article is focused on cheap or expensive as related to the rest of the sector or index.
The Primary Tool For Locating Cheap Stocks
The Price/Earnings Ratio is the primary tool for determining whether a stock is cheap or expensive relative to its peers. Smart investors focus on stocks that are cheap relative to their peers for long term investments.
There are different types of Price/Earnings Ratios. First, let’s take a closer look at the P/E Ratio.
P/E is an acronym for Price/Earnings. It is the ratio of a corporation’s share price to its per-share earnings.
This may seem difficult at first, but it is quite simple.
The P/E Ratio is simply the current stock price divided by its earnings per share (EPS). Here is the formula
The Price/Earnings Ratio is primarily calculated from the EPS over the last four quarters of financial statements. This type of Price/Earnings Ratio is called the trailing P/E.
I like to change things up a bit when it comes to using the P/E ratio to locate cheap stocks for longer term investment. I have found that rather than using the EPS from the last four quarters, it makes more sense to use the forecasted EPS for the next four quarters. The reason for this is the fact that the past does not equal the future in the stock market. While the projected EPS may not be exactly accurate, analysts often have a very good idea about what to expect for the next year in terms of EPS.
This type of Price/Earnings Ratio is called the leading or estimated P/E.
Some analysts use a hybrid of the leading P/E and the trailing P/E Ratios. This calculation is exactly as it is described utilizing the EPS of the past two quarters and estimates of the next two quarters.
It is important to understand that the average P/E ratio in the overall U.S stock market is historically from 15-25. The number varies dramatically due to changing the changing economic climate.
A Note Of Caution!
It is critical that investors remember that low P/E stocks are not necessarily bargains. There are many reasons a company boasts a low P/E Ratio. The primary reason is that something very bearish has occurred with the company causing investors to simply lose interest in the stock. Sometimes this bearish sentiment can last a long time meaning that the stock price will languish at low levels for an extended period.
Due to this fact, finding cheap stocks is just the first step in a profitable investing plan. Once you locate stocks with relatively low P/E Ratios, make certain there are bullish catalysts or changes taking place within the company that will lift shares out of the doldrums. The combination of a low P/E Ratio and a pending long term bullish catalyst is unbeatable for locating winning stocks.
Now that you understand how to calculate the Price Earnings Ratio, here are the three cheapest stocks in the S&P 500 as determined by the estimated P/E Ratio.
- American Airlines (NYSE:AAL)
American Airlines is the cheapest stock in the S&P 500 with an estimated P/E Ratio of 5.4. The average P/E Ratio of the S&P 500 right now is 17.5, over 300% higher than American Airlines.
The reason the P/E Ratio is so low is multi-fold.
The primary reasons are because of competition and Latin American weakness.
In addition, the low forward P/E number reflects the fact that investors are just not interested in the stock. Therein lays our opportunity.
The Airliner has multiple pending bullish catalysts in the works that should work to lift the shares over the longer term.
Namely, the company just experienced its most profitable quarter in history with $1.2 billion earnings in the first quarter of 2015.
American has orders for over 600 new aircraft. This will ramp up the economies of scale and greatly increase profits over time.
The airliner reported as of March 31, 2015, it held approximately $9.9 billion in total cash and short-term investments, of which $757 million was restricted. The Company also had an undrawn revolving credit facility of $1.8 billion.
Also in the first quarter, the Company returned $260 million to its shareholders through the payment of $70 million in quarterly dividends and the repurchase of $190 million of common stock, or 3.8 million shares, at an average price of $49.47 per share.
Add in the macro bullish catalysts like improving economy, low fuel prices, stronger real estate market and overall positive consumer sentiment and it spells a bullish future for the company.
- Ensco (NYSE:ESV)
This offshore drilling company has the second lowest P/E Ratio in the S&P 500 at 6.4. Low fuel prices and general malaise in the industry has pushed shares sharply lower. Let’s take a closer look.
Ensco plc (Ensco) is a global offshore contract drilling company. The Company provides offshore contract drilling services to the international oil and gas industry. The Company operates in three segments: Floaters, which includes its drill ships and semisubmersible rigs; Jackups and Other, which consists of management services on rigs owned by third-parties. Its Floaters and Jackups segments provide contract drilling. It owns and operates an offshore drilling rig fleet of around 70 rigs, including seven rigs under construction, with drilling operations in markets around the globe. Its rig fleet includes around 10 drill ships, 13 semisubmersible rigs, five moored semisubmersible rigs and 42 jackup rigs. Of its 70 rigs, around 17 are located in North and South America, 17 are located in the Middle East and Africa, 17 are located in the Asia Pacific rim (including five rigs under construction), 15 are located in Europe and the Mediterranean and fits are located in Brazil.
The specter of climbing fuel costs, two fresh contracts, and a strong floater fleet will enable Ensco to weather any further downturn and set the stock up for a long term move higher.
- General Motors (NYSE: GM)
The iconic American automobile company boasts the third lowest P/E Ratio in the S&P 500 at 6.4. This number barely beats our Ensco for third place.
The company just reported strong operating results for the second quarter. Although the company missed revenue estimates, it beat on earnings.
General Motors reported revenues of $38.2 billion, $1.5 billion less than last year.
The bullish news is that General Motors posted strong year-over-year earnings progress. During the second quarter of 2015, General Motors described earnings of $1.1 billion, sharply more than the $0.2 billion last year.