How to Determine if a Stock Is Cheap or Not

Thinking of buying stocks but don’t know which are good buys now? Read this to get an idea.

| More on:
analyze data

Image source: Getty Images

You’re reading a free article with opinions that may differ from The Motley Fool’s premium investing services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn more

One of the most common questions investors ask is if the stocks they’re considering cheap. After all, no one wants to pay an expensive price for their stocks.

Here are some of the things you can look at.

Stock type

A commonly used metric to help determine if a stock is cheap is the price-to-earnings ratio (P/E). It’s common for new investors to think that stocks with high P/E’s are expensive. However, it’s not necessarily so. Consider the context of the stock.

The type of stock you’re considering matters. Stocks from different industries will have different P/E’s. For instance, you can’t compare the P/E of a bank to that of an energy stock.

For example, Toronto-Dominion Bank (TSX:TD)(NYSE:TD) stock would be considered a value stock. It’s fitting to use its P/E to help determine if it’s cheap or not. You can compare its P/E to its historical P/E as well as its peers’.

At under $83 per share, it trades at about 12.2 times this year’s earnings, which roughly aligns with its long-term P/E of about 12.

You would value a growth stock very differently. A growth stock that has high earnings-per-share growth of say 15% a year could trade at a P/E of 30 or higher. However, if it exceeds expectations by growing 20% a year, the P/E can further expand and the stock will go higher. On the contrary, if it grows by only 10%, it will experience P/E contraction and the stock could fall to a P/E of 20 or so.

In fact, some growth stocks don’t even have earnings yet. Yet, they can still experience monstrous price appreciation from high revenue growth!

Analyst price targets

For most investors, it’s helpful to look at analyst price targets. Generally speaking, it’s better to look at the consensus price target. Across many analysts, any bias will be diluted in the consensus target.

There are several things you need to be careful about. First, analyst price targets will change over time as the business or environment changes. For example, when the pandemic hit, analysts cut the price targets to many stocks and lifted them again as the macro environment improved.

Second, analyst price targets may be outdated because of the changes mentioned earlier.

Third, under covered stocks with few analysts’ coverage may have a bias price. For instance, a small-cap stock might only have one or two analysts covering it. If they’re both overly optimistic about the stock, the price target would be higher than it should be compared to if 10 analysts covered it.

The Foolish takeaway

Determining whether a stock is cheap or not may not be so clear cut. With dividend stocks like TD stock that have quality earnings, it would be relatively straightforward to determine its valuation by comparing its historical P/E to this year’s P/E based on normalized earnings.

That is, during the pandemic, its P/E was super high due to an expected drop in earnings. It would be the right thing to do to determine its valuation based on its earnings power in a normal economic environment. If you did that, you would have found the stock to be a bargain last year during the market crash.

Growth stocks’ valuations are more unpredictable, especially if their earnings or revenue growth can vary greatly.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Kay Ng owns shares of The Toronto-Dominion Bank.

More on Bank Stocks

Dial moving from 4G to 5G
Tech Stocks

TFSA Investors: 2 Canadian Stocks With Unbelievable Staying Power 

Amid economic uncertainty, investors look for stocks that can thrive in any crisis and grow long term. Here are two…

Read more »

Happy Retirement” on a road
Bank Stocks

Got $10? You Can Still Reach Riches for Retirement

You could have six figures by retirement by simply choosing a strong, safe stock that's down and putting aside $10…

Read more »

edit Four girl friends withdrawing money from credit card at ATM
Bank Stocks

Why TD Bank Stock Is an Absolute Steal for Passive-Income Investors

TD Bank (TSX:TD)(NYSE:TD) looks like a screaming bargain for passive-income investors looking for strong and cheap bank dividends.

Read more »

Bank Stocks

RRSP Investors: Should You Buy TD (TSX:TD) Stock Now?

TD (TSX:TD) stock looks cheap after the big pullback in recent months. Is this the best time to buy TD…

Read more »

Bank sign on traditional europe building facade
Bank Stocks

Beginners: The Top Bank Stock to Buy Before it Rockets Higher

TD Bank (TSX:TD)(NYSE:TD) is making big moves in the M&A department following the recent slide in the financial scene.

Read more »

A plant grows from coins.
Dividend Stocks

4 Stocks That Could Turn $100,000 Into $500,000 by the Time You Retire

Building retirement wealth is a long process, but it’s possible for $100,000 to grow to half-a-million dollars over time.

Read more »

edit Colleagues chat over ketchup chips
Bank Stocks

My Favourite Bank Stock is a Top Buy in This Bear Market

Bank of Montreal (TSX:BMO)(NYSE:BMO) is a great Canadian bank stock that's becoming far cheaper than the pack.

Read more »

Businessperson's Hand Putting Coin In Piggybank
Bank Stocks

Own a TFSA for Better or for Worse

The TFSA is a financial partner for life, and users aren’t missing out, even if they’re unable to contribute or…

Read more »