3-Point Checklist for Investing in Cheap Stocks

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Value investing refers to the practice of buying stocks for less than their intrinsic value, with the goal that the stocks will outperform peers over time. This is how Warren Buffett invests, and doing it successfully is how he's accumulated billions of dollars in wealth over the years. However, determining which stocks are trading cheaply can be complicated. Here are three steps to take that can help you find cheap stocks.

1. Know what a cheap stock is

Before you can start to invest successfully in cheap stocks, you need to clearly define what a cheap stock is. The phrase can have several definitions -- for example, any stock that trades for less than $5 per share can be considered "cheap," however these rarely, if ever, make good investments.

Instead, when I refer to cheap stocks, I mean stocks that trade for a lower valuation relative to their growth potential than their peers. For example, if two companies in the same industry are expected to grow earnings at a 10% annualized rate for the foreseeable future, and the stocks trade for P/E ratios of 15 and 18, the lower of the two could be referred to as "cheap."

This is referred to as "value investing," and the basic idea is that if you buy stocks that are trading for less than their intrinsic value, your portfolio should (theoretically) outperform the market over time.

2. Use more than just the P/E ratio

The most well-known metric in value investing is the price-to-earnings, or P/E ratio. Simply put, this means how much value the market is placing on the company's profitability. For example, if a stock that earned $2 per share over the past year, and it is trading for $30, some simple mathematics shows a P/E ratio of 15.

While the P/E ratio is certainly a good start, and can be useful for comparing similar companies, it's a good idea to use several other metrics in your analysis to get a more complete picture of the company's valuation.

Just to name a few, here are some good metrics to look at, with links to thorough descriptions of how to use each one:

Price-to-earnings-growth (PEG) ratio -- This is a great metric for comparing companies with high growth rates, or companies that are simply growing at different rates. This metric is calculated by dividing the P/E ratio by the company's expected earnings growth rate, and the basic idea is while a company may be growing rapidly, it could still be "cheaper" than another company with a lower P/E ratio.
Price-to-book (P/B) ratio -- This ratio shows how much investors are paying for the company's assets. For example, a price-to-book ratio of 2.0 means that the company's stock is trading for twice the value of its assets. This can be a good comparison of companies in the same industry, but should be used in conjunction with other profitability metrics.
Debt-to-equity ratio -- In general, value investors tend to avoid companies with high debt levels. However, the dollar amount of a company's debt doesn't tell the whole story. For example, a company with $1 billion in debt and $5 billion in equity is probably far more financially solid than one with $100 million in debt and $100 million in equity. Therefore, comparing debt-to-equity ratios can be useful.
Free cash flow -- This tells investors how much cash is flowing into (or out of) a company. Value investors generally want to find companies with positive free cash flow, especially in difficult economic times.

3. Make sure it's not cheap for a reason

Finally, and this is perhaps the toughest thing on this list to do, is making sure the stock isn't cheap for a reason that isn't revealed in the metrics. For example, if a stock trades at a low P/E but its debt-to-equity is through the roof, it's easy to figure out why it's so cheap. On the other hand, eroding market share or declining sales require a bit more digging to figure out.

As a personal example, Transocean (NYSE: RIG), a stock I own, trades for 2.9 times its last 12 months of earnings. However, sales have declined sharply and there is a lot of uncertainty in the energy markets right now, so this needs to be taken into consideration by prospective investors.

The bottom line is to know what makes a stock cheap and worth buying. There are plenty of "cheap" stocks out there -- the challenge is narrowing it down to those that will deliver strong performance over the long run.

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Matthew Frankel owns shares of Transocean. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.