Do Not Mix up a Stock’s Affordability with Value

Let me ask you a question.

Stock A is trading at S\$1 a share. Stock B is trading at S\$10 a share. Which of the two stocks is cheaper?

If you say, “The answer is absolutely Stock A”. I am sorry, but I believe you might need to reconsider your answer. Most likely, you have confused a cheap stock with an affordable stock. As I write, many investors have lost money as they fail to appreciate the difference between the two.

You may ask, “Are you saying that it is possible for Stock B to be cheaper than Stock A?”

My answer is, “Yes, it is possible”. Let me elaborate.

For a start, we cannot tell whether a stock is cheap or expensive based on its price alone. Most savvy investors would ask for additional information to help them assess the valuation of a stock. A stock’s earnings per share (EPS) is one of the information required. It is useful for investors to compare stock prices to their earnings. This is known as the Price-to-Earnings ratio (P/E ratio).

So, let’s say, Stock A has EPS of S\$0.02 and Stock B has EPS of S\$1.00.

For Stock A, at a hypothetical trading price of S\$1, its P/E ratio works out to be 50 (S\$1 / S\$0.02). Thus, the trading price of Stock A is equivalent to 50 times of its earnings.

Meanwhile, at a hypothetical trading price of S\$10 for Stock B, its P/E ratio works out to be 10 (S\$10 / S\$1). Thus, the trading price of Stock B is equivalent to 10 times of its earnings. As such, Stock B is cheaper than Stock A in terms of earnings despite Stock A being more affordable than Stock B.

You may ask, “But how is this helpful for me to make money in the stock market?”

Good question. Here’s what I have in mind:

1. Avoid stocks that are incurring losses. These stocks have no EPS as they are reporting losses per share. We can find plenty of stocks that are reporting EPS. So, why do we need to take unnecessary risks on stocks that don’t make money?

2. Avoid stocks that have high P/E ratio. If you spend S\$50 million to buy a business that makes S\$1 million a year, what is your return on your investment? The answer is 2%. Instead, if you spend only S\$10 million for the same business, your return would be 10% a year. As such, it is more attractive to buy a profitable business at its lowest possible price. Go for a good stock with a low P/E ratio.

3. Avoid stocks that have huge fluctuations in P/E ratio. Why? In most cases, stocks that have massive fluctuations in P/E ratio are those that report huge fluctuations in earnings. This means they make more money in good times and less money in bad times. If you intend to build a low-risk resilient portfolio that withstands both good and bad times, you can begin by finding stocks that have a track record of delivering sustainable profits over the long-term.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.