Picking stocks with low prices is not enough. Thanks to the market's May swoon and seven-for-eight losing streak earlier this month, there's no shortage of low-priced U.S. stocks in 2012. But many of those are destined to chug along forever with low prices - or go bust altogether.
At the same time, some U.S. stocks priced at $100-plus per share could be considered bargains.
The key in both cases, of course, is value.
Only by comparing a stock's price to its underlying value can you decide whether it's a "bargain."
Unfortunately, it's not quite as easy as it sounds. There are almost as many definitions of "value" as there are securities analysts.
However, most agree on the following fundamental measures of intrinsic worth:
- The stock has a low price/earnings (P/E) ratio relative to other companies in its industry segment or the market as a whole.
- The P/E ratio is below the stock's own average P/E over the past 10 years or so.
- The company's earnings history is stable - i.e., the low P/E is not due to unusual capital gains or some other one-time revenue event.
- The company's earnings have increased for the past three years on stable or rising cash flow.
- The stock is selling at a price below book value - i.e., the company's tangible assets are worth more than the value of the outstanding common stock.
- The company has little or no debt - and, if there is debt, it is rated "A" or better.
- The current low stock price is not the result of a sharp drop in operating margins, management shake-ups or some kind of financial scandal.
- In spite of its solid fundamentals, the stock price is lagging others in the same industry segment.