How to Know if a Stock Is Cheap (With Live Examples)

Cheap is about value, not the share price

A $5 share can be expensive and a $500 share can be cheap. The price per share only tells you how many pieces the company is cut into. What matters is the price of the whole business (the market capitalisation) compared with what that business earns, owns and is likely to earn later.

Imagine two companies that each earn $1 billion a year. One has 100 million shares at $200 each, the other has 1 billion shares at $20 each. Both are worth $20 billion on the stock market and both trade at the same 20 times earnings. The $20 share is not "cheaper".

So "cheap" always needs a comparison: against an estimate of what the company is worth, against its peers, or against its own past. The three checks below are those comparisons.

Check 1: compare the price with fair value

Fair value is an estimate of what one share is worth, based on the cash the business generates. ATLAS builds it from a 10-year discounted cash flow and from the valuation of similar listed companies, and shows it as a mid-point with a range and a confidence level. Read the full method in how ATLAS calculates fair value.

ATLAS describes the gap in plain words: the price is "below fair value" when it sits at least 15% under the mid-point, "above fair value" when it is at least 15% over, and "close to fair value" in between. The table shows real figures for the largest S&P 500 companies. A negative gap means the price is below ATLAS fair value.

Check 2: compare the P/E with peers and with its own history

The price-to-earnings ratio divides the share price by the earnings per share of the last twelve months. A P/E of 15 means you pay $15 for each $1 of yearly profit. On its own the number says little: software companies usually trade at higher multiples than banks or utilities, so compare a company with others in the same industry.

Also look at how the same company's P/E has moved over the years. A stock trading at a P/E far below its own five-year range may be cheap, or the market may be telling you earnings are about to fall. That leads to the third check.

Check 3: find out why it looks cheap

A low price is often a warning, not a bargain. The most common reasons:

• Earnings at a cyclical peak. Steel, oil, shipping and chip makers can show a very low P/E when profits are at their highest, just before they fall. The ratio looks cheap and is not.
• One-off gains. A sale of a division can inflate this year's profit and make the P/E look low. Look at operating profit and free cash flow too.
• Heavy debt. A company with a lot of debt can have a low P/E because the equity is risky. Compare net debt with annual earnings.
• Shrinking business. If revenue and margins fall every year, the "cheap" price may still be too high. This is called a value trap.

A five-minute routine

1. Open the company page and read the fair value range and the confidence level. Low confidence means ATLAS itself is unsure.
2. Compare the P/E with the sector median shown on the same page.
3. Check whether revenue and free cash flow have grown or fallen over the last four years in the financials, which link to the SEC filings.
4. Look at the next earnings date. A report can change the picture overnight (see how to read an earnings report).
5. Decide how much margin you want between price and value. That buffer is the margin of safety.

What this does not tell you

No valuation tells you when the price will move. A stock below fair value can stay there for years, and a stock above it can keep rising. Fair value is an estimate with a range, built from stated assumptions, and the model can be wrong. ATLAS publishes its track record so you can see how its probabilities compare with what happened.