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As a new stock investor, your toughest job is finding quality, inexpensive companies to buy. You want a stock that will likely go up in the future, and you don’t want to pay too much for it now.
So what, exactly, is an inexpensive stock? Perhaps a more accurate way to describe cheap stocks is with the term "undervalued." An undervalued company may, for example, have strong fundamentals in place, but the market hasn't yet caught on, and the current price of the stock doesn't accurately reflect the true, potentially higher value of the company. (This dovetails with the investing strategies surrounding value and growth stocks.) In other words, undervalued stocks offer good value for the money, not just a low share price.
There’s a quick way to begin searching for these stocks, and it’s available at many brokerages: a stock screener. It’ll help you sort stocks by any criteria that you think are important, so you can focus on the most likely candidates for further research.
Here's an example. In the table below, we're screening today's current cheap stocks, defined as companies in the S&P 500 index that are currently less than $20 per share and have a positive YTD performance. (We've also screened out stocks with a current share price below $5, typically considered penny stocks.)
Stock data is from Google Finance and may be delayed up to 20 minutes, and is intended solely for informational purposes, not for trading purposes. Ultimately you have control over the inputs and criteria you use to run your stock screener search.
But finding candidates is just the start of the process, as investing in individual stocks requires a lot of work. You’ll need to:
Understand the various types of stocks.
Investigate the company and its management.
Research the industry.
Evaluate the financials, such as the balance sheet and income statement.
Follow the company’s quarterly reports.
That’s just the minimum that you need to do. So if this isn’t how you want to spend your evenings and weekends, then consider buying an index fund. Put money in it regularly and go have fun.
For everyone else wanting to make individual stocks a potentially lucrative hobby, here’s your guide.
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How to find cheap stocks
1. Choose a stock screener
First, find a stock screener. Most online stockbrokers have them (learn how to open a brokerage account to get started), and financial sites such as Yahoo Finance do, too. The screener allows you to sort by almost any characteristic you can imagine. You can input traits that you want your results to have, such as annual sales growth above a certain level, say 10%.
Growth rates and value are relatively basic criteria, so the example in this article will screen for stocks on these dimensions. Better screeners will offer more criteria and more customization.
» Interested in stock research? Read our review of Morningstar
2. Set a target for future earnings growth rate
You can define good companies in many ways, but a typical one is how fast the company is growing. Quick-growing companies tend to be valued more highly by investors, so they’re an attractive place to begin your search for good companies.
On the screener, set up a screen for a company’s future earnings growth rate. A good place to start may be around 10% annually over the next five years; then, try increasing this to 15% or even 20% to see what's available. Earnings growth above 20% is very high.
If the screener doesn’t have a screen for future earnings growth, then use a screen for sales growth. Again, search for companies growing sales (also called revenue) at your preferred growth rate. And if the screener doesn’t have future earnings projections, look in the rearview mirror: find earnings or sales growth for the past five years instead.
» Learn the basics: How to buy stocks
3. Use the P/E ratio to find potentially undervalued stocks
You’ve got a list of fast-growing companies. Let’s add another criterion to the screen and search for companies that are also inexpensive.
“'Inexpensive' refers to undervalued stocks, and not just stocks with a low share price.”
Remember that “inexpensive” here refers to undervalued stocks, and not just stocks with a low share price. There are plenty of stocks that offer a low share price, but in many cases, you may be getting what you paid for.
To evaluate a stock’s value, investors will often divide the current price of one of its shares by its annual earnings per share. The resulting number is called the price-earnings ratio, or P/E ratio. The lower the P/E, the cheaper the company is. For example, investors might be willing to buy Facebook stock at a P/E of 20 this year, while they paid a P/E of 30 last year. If you pay a lower price for the earnings, you’re getting a better deal, all else equal.
On the screener, add another criterion for the company’s current P/E ratio to compare it alongside other factors.
4. Focus on market cap to screen out risky companies
The screener should leave you with dozens of companies that are relatively cheap and that financial analysts think will grow earnings well in the future.
If you end up with more companies than you need, set the minimum size of the company, as measured by its market capitalization, to avoid some of the smaller, riskier stocks. In general, the smaller the market cap, the riskier the company. Large caps, on the other hand, are companies valued over $10 billion.
If your list is still too long, consider adding a few more criteria:
Increase the minimum growth rate, to 15% growth instead of 10%, for example.
Screen for stocks trading near their 52-week low point, to ferret out those that the market has soured on (for now).
Include only companies that pay dividends, which is often a sign of strong financial health.
But the screener is just the start of finding good stocks at a bargain. From here you really have to research the stock. You’ll want to figure out:
If this is such an attractive high-growth stock, why does it look cheap?
What does the company do? And does the industry have a future?
How is the management, and is it aligned with shareholders?
How do the company’s balance sheet and other financials appear?
Answering these fundamental questions is a big task, especially if you’re aiming to have a well-diversified portfolio. And after you’ve purchased your stocks, you’ll want to keep up with the companies by analyzing at least the quarterly earnings reports.
If you’re looking to dig into investing in stocks, open an account with a broker that provides good screening and research, including the work of professional analysts that can help you get started.
» Ready to compare? See our picks for the best brokers for trading stocks
Disclosure: The author held no positions in the aforementioned securities at the original time of publication.