That Cheap Stock Might Actually Be Very Expensive: Here's Why

Price is what you pay; value is what you get.

-- Warren Buffett, quoting his mentor, Benjamin Graham 

Lots of new stock investors and even some experienced ones don't have a good understanding of what a stock's price really means. That's bad news, because lacking that comprehension can lead to costly consequences.

Image source: Getty Images.

A stock's price

It's easy to see how people can assume incorrectly. If you're shopping for a pair of shoes and you're looking at one pair that costs $25 and another pair that costs $75, there's clearly a cheaper option and a more expensive one. That's how many people view stocks: They think that a stock priced at, say, $25 per share is cheaper than one priced at $75 -- and that the $25 one is a better bargain. But that's not necessarily true at all.

Think back to the shoes. If the $25 price tag is for a pair of flip-flops on sale at a drugstore, while the $75 price tag is for a pair of all-leather dress shoes made by a well-regarded company, you might actually view the $75 pair as more of a bargain.

A stock's price alone really tells you very little. It needs to be compared to other measures in order to be informative. Check out the following companies and their share prices on a single day in August.

Source: finviz.com. 

Just looking at the share prices doesn't tell you anything about the company, right? Is Alphabet, the parent of Google, really that similar in value to Yum! Brands, parent of Taco Bell, KFC, and Pizza Hut? Are they both more bargain priced than, say, IBM, which has a slightly higher stock price? Not necessarily. A $5 stock can be wildly overvalued and due to fall, while a $500 stock can be a bargain, on its way to $1,000 and higher. 

Let's add a new column to that table -- showing market capitalization, which is the total value of all outstanding shares. It's essentially the price tag, at the moment, for the entire company:

Source: finviz.com. 

Now you have a lot more information. You can see how the market has been valuing each company recently. Amazon.com and T-Mobile, for example, recently had roughly the same share prices -- but vastly different market values.

To understand how they can be so different in size with similar share prices, look at their shares outstanding. Amazon recently sported 10.3 billion shares, while T-Mobile had 1.2 billion. (Multiply 10.3 billion shares by the $134 share price, and you arrive at a market capitalization of $1.4 trillion.)

Price and value

When you're investing in a stock, you'll ideally be doing so as a long-term investor -- because the stock market can be rather unpredictable over the short term. If you're a good value investor, in the company of respected investors such as Warren Buffett and Shelby Davis, you'll be aiming to buy a stock when its current share price seems meaningfully lower than its intrinsic value -- when it has a margin of safety.

Unfortunately, you can't simply look up a stock's intrinsic value. The best you can do is come up with your own estimate, or refer to estimates others have arrived at. There are simple and complicated ways to value a stock, and none of them will always be perfect. Beginning investors might start with the price-to-earnings (P/E) ratio for an easy way to roughly judge how undervalued or overvalued a stock might be.

To calculate a P/E ratio, you simply divide the stock's price by its earnings per share (EPS) over the past year. (Some prefer to calculate a forward-looking P/E ratio, which uses the expected EPS over the coming year.) So with Target, for example, divide the stock price of $125 by its EPS of $7.28, and you'd get a P/E ratio of 17.2.

Below are our 10 companies with their P/E ratios. (Note that two companies don't have P/E ratios because they posted losses instead of earnings over the past year.)

Sources: finviz.com and Yahoo!Finance. 

We can now make much more sense of these companies' values. Amazon's P/E ratio of 106.7 means that at its recent price, you'd be paying $106.70 per dollar of earnings -- while for a dollar of Target's earnings, you'd only pay $17.20 or so. Clearly, investors have high expectations for Amazon.com. 

There's a little more nuance to appreciate here. For example, industries that are capital intensive, such as railroads or automakers, will tend to have low, even single-digit P/E ratios, while those in more capital-light businesses such as software or e-commerce will command higher ones. So compare a company's P/E ratio to the ratios of its peers -- and to its own five-year average P/E ratio, too.

There's much more to learn about how to value a stock, if you're interested. If you're not, remember that you can always just invest regularly in a low-fee, broad-market index fund. That's a great way to build your wealth, too.