What does cheap mean?

I’m a relatively new investor, certainly new to the recent volatility. Can the more seasoned investors out there share how they are working out what cheap means?

Cheers

Hi,
There are many metrics you can look at, and everybody has their favourite. But the most common are PE ratio, P/CF ratio or the PEG ratio.
You have to google what they mean and understand to evalutate yourself.
But you can never actually know if something is ‘cheap’, otherwise everybody would buy that stock and would in the process make it expensive - like a self fulfilling prophecy. This would mean that each stock is priced exactly as the market evaluates it and cheap or expensive does not exist.
Your call. :wink:

3 Likes

Read 1993 newsletter of Buffet about how they value businesses. They are mainly using DCF (Discounted Cash Flows). In their case, cheap relative to US Treasuries. The million £ question, is it better to invest in company XYZ or will I get better return parking the money in US Treasuries / UK Gilts? This is one way to apply DCF analysis.

Intrinsic value is a present-value estimate of the cash that can be taken out of a business during its remaining life. - Warren Buffet,

[1993 letter to shareholders.](https://www.berkshirehathaway.com/letters/1993.html

“The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure… two people looking at the same set of facts… will almost inevitably come up with at least slightly different intrinsic value figures.“

https://www.youtube.com/watch?v=Ja8vu_leDio

My personal screening metrics

  • Fwd P/E and P/E less than 20 (or less than the market index)
  • Dividend growing on average 8% or more per year for the past 10 years
  • While maintaining a payout ratio of less than 60%
  • Debt / Equity less than 0.5
  • Piotroski F-Score of 6 or more.
1 Like

I would use a range of valuation metrics, this should give a more rounded picture of the business. You should also check this against other businesses in the same sector, and then against the wider market.

PE is commonly used (price/earnings per share), but the earnings per share number can be calculated in a number of ways, so worth checking you’re comparing apples with apples if using it.

Cyclically Adjusted PE can be more useful than PE. It sounds complicated, it’s not -
take the average earnings over a number of years as the denominator (typically 10 years), then you get a view of company performance over time. It helps smooth out peaks and troughs of company performance.

If you are trying to understand some sort of absolute value of the business, then the DCF model mentioned above is probably your best starting point. But this does include a number of assumptions, one of which is choosing a “risk free rate” which is usually government backed borrowing, a bond of some duration. At the moment the bond market is as crazy as the stock market so once again a bit of care is needed.

Metrics I use to assess quality:
Return on capital employed - profit generated from capital
Net margins - tells you how much will be left over once all bills are paid
Debt vs net profit - low debts much preferred
Price to free cash flow - cash flow is more transparent than earnings
Dividends growing by more than the rate of inflation, preferably 5%+
Dividends covered by cash (dividends are paid from cash, not the profits recorded on the income statement)

Price is driven by sentiment in the short term. Over the longer term the fundamentals of the business will drive the price. If you focus on quality rather than price your investments should be fine - if a little volatile at times.

Good luck.

3 Likes

Nintendo PlayStation - cheap or expensive?

The era of the 25x-50x earnings (or any crazy EBITDA and Sales multiples) is over for now. The bubble has burst.

Decided to have a quick poke around in the price data to see who from the FTSE100 is getting beaten up the most, google sheet here.

3 Likes

Very interesting topic. “Cheap” of a company’s stock needs to be relative to its underlying performances. Warren Buffet considers “cheap” relative to the cash flow a company can generate in the future, and calculate what are those cash flow are worth in today’s value. It needs a lot of assumptions on cash flow for every year, and what rate one uses to discount those cash flow back to today. Unless one works in asset management industry or investment research, it is very difficult to calculate the fair value for every company because it is a lot of work. His approach also does not apply to newer companies or those company whose cash flow is quite patchy. This is why Buffer invests mostly in established and stable companies these days.

Most people will just use the multiples approach such as market cap relative to earnings or free cash flow. It is pretty simple to understand and most importantly easier to calculate.

I found this article from Simply Wall st quite useful and detailed:

And Genuine Impact explains “cheap” quite clearly as well in their app:
IMG_4CB213B30F9E-1

Also they have a value screen and you can filter by each market:

I use these two providers now to help me get a sense of stock investing. Both don’t just cover “cheap” aspect of picking a stock, but also covers things like quality, momentum, dividend etc etc.

1 Like