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How Cheap Should a Stock Be Before You Buy it?

We hear others saying that stock ABC is cheap or stock XYZ is expensive. How do you determine if a stock is cheap enough to buy? Here’s the short answer: ultimately, you have to decide how cheap a stock must be before you’re willing to risk your hard-earned savings by investing in it.

I’ll explain using Toronto-Dominion Bank (TSX:TD)(NYSE:TD) as an example.

How do you value Toronto-Dominion Bank?

You can value a stock using different metrics. One of the most popular metrics is the price-to-earnings ratio (P/E).

Toronto-Dominion Bank’s trailing 12-month earnings per share (EPS) is $5.06. Based on its recent quotation of $64.71 per share, it trades at a trailing 12-month P/E of nearly 12.8. Some analysts believe the bank can generate EPS of $5.35 this fiscal year, which represents a forward P/E of almost 12.1.

Since 2007 the bank has normally traded between a P/E of 11.9 and 14.2. An outlier occurred in 2008 when the stock traded at an exceptionally cheap P/E of 8.9 during the Financial Crisis.

So, Toronto-Dominion Bank is reasonably priced today, and its shares should steadily head higher if nothing out of the ordinary, such as a market correction, occurs.

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Is the bank cheap enough for purchase today?

Traditionally, value investors wait until a stock is exceptionally cheap before buying, like when the bank (along with most other companies) tanked during the Financial Crisis.

But nowadays, the term “value investing” is used quite loosely. Some value investors require a 30-50% discount. Others may buy even when a stock is reasonably priced. So, yes, that would include Toronto-Dominion Bank today.

The key point to remember is, the less you pay for a stock, the more value and higher returns you get. For a dividend stock, such as Toronto-Dominion Bank, you’ll also get a higher yield by paying less per share.

However, when a stock is cheap, something could be wrong with the stock, the industry, or the market. In the Financial Crisis, the banks were truly affected, even if it was only temporary.

Specifically, in fiscal 2008, Toronto-Dominion Bank’s EPS declined 15%. But by fiscal 2010, its EPS had already recovered to its fiscal 2007 level. And the stock price recovered even quicker than that; it bounced back to a reasonable multiple by August 2009.

So, what’s the lesson here?

Using valuation metrics, such as the P/E, we can determine if a stock is cheap or not. Analyzing if a cheap stock is a good value is another matter. A cheap stock can be cheap because there are some serious problems with it.

In the case of Toronto-Dominion Bank, its earnings decline in 2008 was temporary. If investors recognized that at the time, they could have purchased a quality stock at a bargain price.

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Fool contributor Kay Ng has no position in any stocks mentioned.

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