Why a low price Stock Isn't Necessarily a Cheap Stock

One of the most common mistakes that new investors make in the stock market is to pick a stock based on the price of the stock. They think that buying more stocks at lower prices (say 500 stocks at Rs 10 each instead of 5 stocks at Rs 1,000 each) is a safer or more rewarding option for the same amount of investment.

They typically think it’s easier to double a ₹10 stock than a ₹1,000 stock. The truth is that both take a precise 100% gain to double your money. But a low share price does not mean it is a good or inexpensive deal for investors. Investors should look at the genuine growth possibilities and intrinsic worth of a firm rather than just the price of one share.

Share Price and Market Capitalization

The share price tells us the cost for one share and the market capitalization tells us the overall market value of a company.

Market Capitalization = Share Price * Total Number of Shares Outstanding

Trading below ₹100 for Large Market Capitalization Indian Companies

How can investors tell when a stock is cheap?

Smart investors don't just look at stock prices when they examine stocks. They benchmark the company’s earnings, assets, revenue and valuation against those of comparable companies.

There are three popular value multiples:

Price/Earnings Ratio (P/E)

P/E ratio reveals how much an investor is ready to pay for every rupee earned by the company.

A lower P/E could suggest it’s cheap, or it could mean bad growth or diminishing earnings. A company with solid earnings growth may deserve a higher P/E than a company whose profits are declining.

Price/Book (P/B) Ratio

The P/B Ratio is a ratio that compares the market valuation of a firm with its book value (assets minus liabilities). This is especially beneficial when you look at banks and financial organizations.

Banks trading below book value could look tempting but investors should also examine their asset quality, profitability and financial soundness.

Price to Sales Ratio (P/S)

The P/S ratio is a ratio that compares a company’s annual sales to its market valuation. It is useful to evaluate companies that are growing sales but have little or no profit.

Two companies with equal revenues, however, can have substantially different profit margins. Thus a lower P/S is not always a good investment.These ratios are more useful when compared to companies in the same industry.

Valuation is not enough

A cheap stock isn't necessarily a deal. Investors also must look at the company's sales and profits growth, its debt and whether it produces enough cash from operations.

They should also look at how well the firm is using its money, looking at ratios like as ROE and ROCE, the quality of its management and the potential growth of the industry it is in. A low P/E or P/B stock might be a bad investment if the company’s financials and prospects are bad.

Cheap stocks are popular and so are the risks

There are thousands of low priced stocks in the Indian market, most of them from small-cap and micro-cap companies. Some of these businesses don’t have regular quarterly earnings calls or detailed investor presentations as larger companies do. The lack of information impairs investors’ ability to understand their financial performance, business goals and prospects for future growth.

A number of these stocks are also lightly traded thus it’s tough for investors to acquire or sell a lot of shares without affecting the share price. These equities are also more susceptible to speculation, rumors and misinformation on social media. So a stock that is trading at a cheap price or around its 52-week low is not necessarily a good purchasing opportunity.

Price manipulation is one of the major concerns with penny stocks. This means that a few traders can move the share price of some of these firms with low trading volumes and less engaged investors. In some cases, stock prices are pushed higher by rumors and false recommendations. Such traders can push prices down when they exit their positions, leading to huge losses for retail investors.

The other huge problem is bad company governance. Smaller enterprises may have inferior financial reporting, questionable business practices, or a history of not complying with disclosure regulations. Warning indicators investors should look out for include changes of auditor, delays in financial reporting and odd promoter transactions.

The potential of financial failure and trade restrictions is another factor that investors should consider. Companies regularly making losses, with large debt levels and poor cash flows could find it difficult to survive. In more catastrophic circumstances stockholders could lose most, or all, of their investment. Some equities may also be subject to trading limitations, price bands or suspension due to regulatory or compliance reasons, making it difficult for investors to sell their positions.

But a stock should not be regarded attractive because it has fallen abruptly or is at a very low price. It is also vital to know the financial state of the firm, the quality of its management and its trading activities before making a decision to invest in it.

Summary

The stock market pays you if you know the value of a business, not if you acquire more shares at lower prices. A stock priced at ₹10 may be pricey whilst a stock priced at ₹1,000 may be excellent value. The difference lies in the fundamentals of the company, its earnings potential and the price investors are paying for it.

Investors should understand the businesses, research the financial statements, compare valuations and look for companies with great growth prospects instead of chasing the cheap stocks for rapid returns. If you invest frequently without understanding the business it is simply speculation.

“Successful investing is not about picking the cheapest stock, it is about picking a good business at the right price.” The more investors focus on studying and comprehending fundamentals, the more they will be able to make informed investment decisions and grow wealth over time.