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Basic Metrics for Finding Cheap Stocks

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If identifying cheap stocks were easy, then we would likely all be doing it, and therefore would all be rich. Since we're not, and many investors know all too well the pain of overpaying for a stock, our next installment of Investing 101 is about putting the proper price tag on investments.

To do so, we brought in Jim O'Shaughnessy, founder of O'Shaughnessy Asset Management and author of "What Works on Wall Street" to talk about the two most common metrics for finding cheap stocks.

Price to Earnings, or P/E Ratio

If you had to pick just one method for determining whether or not a stock is cheap, the Price to Earnings, or P/E ratio, would have to be right at the top of the last. "Basic P/E is as simple as it gets," O'Shaughnessy says in the attached video. "It's probably the number that investors look at the most in trying to determine if a stock is cheap or expensive."

As the name implies, a P/E is just that: The ratio of a stock's price to its earnings, and it is typically expressed as a multiple of earnings. For example, if Nestron Inc was trading at $10 a share and had earned $1.00 per share in profits in the past year, Nestron would have a P/E of 10, or could be said to be trading at 10x earnings.

Of course, investors tweak this basic P/E number in many different ways and apply it to their analysis. One common way is to compare the P/E of a particular stock to the P/E of an index, to determine if it is trading at a discount 0r premium. If Nestron trades at a P/E of 10 but the average stock in the S&P 500 trades at 12x earnings, it could be said that Nestron is valued 20% less than the market.

In reality, O'Shaughnessy says "very few companies have single-digit P/E ratios," adding that his research shows that investors who had "concentrated on low P/E stocks would have done vastly better than an index found" over the long term. Here's the likely reason for this: High P/E stocks are expensive to begin with, while low P/E stocks have often just become cheap for a reason.

One final twist on this basic measure of valuation is what is known as Forward P/E or Estimated P/E. The math works exactly the same except that you plug in what the earnings are expected to be in the future, rather than what they actually were in the past. The problem with that O'Shaughnessy explains, is that if you look at how well analysts have done in predicting profits, they're wildly off the mark and "you could be just flipping a coin."

Price to Sales or P/S Ratio

Because of this unpredictable aspect of forward P/E, O'Shaughnessy often turns elsewhere.

"In my book we found that Price to Sales ratios were better indicators than P/E ratios," he says, calling the former metric a very valuable tool. "What I would urge investors to look at, are stocks where you are paying very little for every dollar of sales."

For example, if Nestron is trading at $10.00 a share and did $5.00 a shares in revenues, it would have a P/S ratio of 2. Just like P/E's, this number can be calculated on trailing (actual) results or estimated figures. And the ratio itself can also be compared to other stocks in a sector or a particular index. In some cases, professionals will graph a stock's P/E or P/Sales ratios over a five or ten year period to see how the current price compares to historical valuations.

"Sales are very, very difficult to manipulate," O'Shaughnessy says "and therefore, give a very good fundamental look."

And again, his analysis shows that investors who owned stocks with "very low P/Sales ratios" ended up doing very well, while "investors willing to pay the moon, ended up doing poorly."

Ultimately, these two tools are all about price and finding value, but they are also used as red flags to warn when stocks are getting a little expensive.

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