You've all seen them . . . stocks that continue to drop that might be a good investment. You want to dive into the stock because it seems cheap. But you're held back because you're also afraid that it's going to go under too. After all, you've seen some cheap stocks go to zero.
So how can you tell a good stock (one that will survive and eventually turn around) from a bad stock (one that's cheap and that will continue to get so cheap it eventually reaches zero, as they go bankrupt)?
The key lies in looking under the hood. You know, before you buy any used car you always hear the person say, "Can we take a look under the hood?"
They always want to hear the engine running with the hood up, etc. Why? They want to see if there are any things that they should be concerned about and if the car is in proper working order.
Well, it's very similar when it comes to stocks. When a stock is diving and seems cheap, first of all you have to determine if it's genuinely cheap or if it just appears that way. And you also have to determine its likelihood of surviving and making the turnaround.
Did you know a stock could trade for $2 per share and be expensive and another stock trade for $100 per share and be cheap? How so?
Well, just because a stock is cheap "per share" doesn't mean you've really found any value. Why? What if you've bought something "cheap" but yet the company doesn't make money anymore and they aren't projected to make money in the coming year? Have you really found a bargain?
And if they do make money, how much money are they making relative to their earnings per share? Thankfully, you can find this out by looking at a company's price-earnings (P/E) ratio. It lets you directly compare the price of the stock relative to its level of earnings to see if you've found a true value or not. A cheap P/E ratio (e.g., 6 to 12) shows you've found a value. Whereas, a high P/E (e.g., 18 to 25), shows you've bought something expensive.
So I've seen $5 stocks that have a P/E of 50 (ultra-expensive) and a stock trading for $100 per share that has a P/E of 6 (very cheap).
Therefore, first look to see if the stock is cheap relative to its earnings and not simply on a per share basis. Otherwise, you might find that you've bought a whole lot of nothing.
Ok, now onto the next point. Make sure you've found a company that will survive and "make the turn" higher.
This is important because there are some companies that even "make money" but that don't steward their overall business well enough and they risk going under. So how do you help drastically increase the odds of a company not going under?
It mainly comes down to two facets: 1) cash and 2) debt.
If a company has deep pockets then their likelihood of going under is slim. If they are bleeding cash and they have little of it left, then there's a huge chance they could go under.
I personally only like to invest in companies that have billions of dollars of cash on their books. Occasionally, I may make an exception. But even then, the company has to have a half a billion dollars or more to make my cut.
Many of you will remember when I made the famous call on Best Buy's stock. The stock had been sinking for years and I was finally calling for it to turn around and recover. Well, the other guests on the show that day laughed. However, the must not have "looked under the hood" like I had. Instead, I think they got swept into the prevailing negative sentiment of the day.
When I looked into the company, I saw that they had a billion or two in cash on their books and that they'd made about a billion dollars or so in earnings that past year. Well, then I knew it couldn't be totally true that they were only a store window for Amazon.com.
Before it was all said and done, Best Buy took off and became one of the year's best performing stocks.
Ok, back to my final point. If they've got plenty of cash on their books, then we also need to ensure that their debt levels are manageable. If a company has debt that is equal to or less than 50 percent of its market capitalization, then it's healthy. If the debt is less than 33 percent, it's in very good shape.
So, the next time you find what seems to be a cheap stock, first find out if it's truly cheap by seeing if it has a cheap trailing and forward P/E. Then if it does, make sure they've got sufficient cash reserves and manageable debt levels. If all of this is the case, you've likely found a stock that's going to survive and turn around to the upside given enough time.
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