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What are cheap stocks? Are stocks trading at their lowest considered cheap? Or perhaps penny stocks are cheap? While they do seem cheap but judging purely on share price is insufficient and doing so can definitely harm your portfolio. Instead, a better option to use is the Price to earnings ratio of the stock or otherwise known as the PE Ratio.

In general, PE ratio simply compares the share price to the earnings of the company. The lower the number, the cheaper the stock is. For cheap stocks, they would normally trade at a PE ratio of less than 10. But before you get excited and start looking for low PE stocks, you need to know that these stocks are selling cheaply for a reason. Most of the time, these stocks are either risky stocks or stocks with no future potential. Therefore, using it on its on may expose you to risky investments that you do not need to get in the first place.

Thus, here are 2 basic rules to follow:

1. Fairly Stable Earnings

Stable earnings refers to companies with a track record of stable profitability. They need not necessarily be on an uptrend. But as long as the profit generation ability of the company is stable, we can expect them to continue such trend into the future. Think about it, if you are able to maintain your grades between B+ and A across many years, it is likely that you may continue that into the future because you are already used to and know very well how to do it. The same goes to companies.

Example of companies with stable earnings:

Example of companies with unstable earnings:

2. Low Debt Levels

This is the second requirement before using the PE ratio to evaluate companies. Always look for companies with very low debt because it is less likely for such companies to go bankrupt, safer to navigate through a crisis and therefore, give investors more confidence of the company. One metric to look out for to evaluate this is the debt to equity ratio or D/E Ratio. D/E ratio measures the level of debt compared to the equity of the company. For a safe side, it is preferred for companies to have a D/E ratio of less than 0.5 or 50%.

The formula for D/E Ratio is as below:

Why invest in low PE ratio stocks?

First its because it is less risky compared to buying growth stocks or stocks which are well known and popular among investors.

The lowest PE ratio for a stock with consistent profit is zero (that is provided that the share price is zero) and the highest PE ratio is unlimited. The higher the price an investor is willing to pay, the higher the PE ratio.

Stocks which are popular means that there are huge demand for the stock. With huge demand, new investors tend to pay higher prices for them. And when investors are willing to pay a high price for them, it simply means that they expect stellar performance from the company and this causes the company to trade at a very high PE ratio. Companies such as Facebook and Alibaba trades at a very high PE Ratio signify strong investor confidence in them.

However, paying a price which is too high with huge expectations are recipes for disaster.

When a stock with very high expectation disappoints, investors will almost always throw away the stock in disappointment resulting in huge losses within a short period of time. And with the high PE ratio, it means that there is a long way down all the way to PE of zero meaning that there is a long way that the share price could fall. PE Ratio can be thought about as a rubber band, the further you stretch it, the more painful it feels when you let it go.

Stocks with low PE ratios on the other hand, are normally not very popular stocks. Due to low popularity, there is little demand for their stock and therefore, the lower the price and the PE ratio will be. With that, normal or mediocre result will be expected. The stocks will be punished less for these results.

Secondly, it is also more profitable to invest in stocks with low PE multiples. For a stock that is already trading at high PE ratios, to get another investor to pay an even higher PE ratio willingly, the stock needs to provide a higher and better prospect than it currently has. Perhaps a new area of growth or more profitable business model on top of the high expectations it already has. It is akin to expecting a student who has consistently scored an A for exam to score 100% consistently instead of just an A. But a low PE multiple stock on the other hand tend to surprise investors with a better than average result. It is also easy for them pay more for the share as well since they are trading at a very low PE Ratio.

Disclaimer: All facts and opinions presented are for educational purposes only. This is not a recommendation to buy or to sell. The author involved in the writing of this message has no vested interest in the companies. Please consult a professional for expert financial or other assistance or legal advice.