When Is a Cheap Share Too Cheap?

LONDON -- As I wrote the other day, it's not difficult to run your eye down the FTSE 100 and spot shares trading on very low price-to-earnings (P/E) ratios.

At the time, I was talking about shares ranked in the upper reaches of the FTSE 100. But rest assured, there are plenty of other cheap-looking shares, further down the pecking order.

Eurasian Natural Resources, for instance, is the second-smallest share in the index, and trades on a prospective P/E of 5.6 -- fractionally lower than Barclays, where the consensus has a P/E of 5.2 penciled in. Put another way, that's around half the P/E of the FTSE 100 as a whole, which is presently trading at around 11.

So are both these shares bargains? If so, at what level does a P/E actually scream "bargain"? Is a P/E of 8 a bargain? Or should it be 7 -- or 6, or even lower?

Out of favor
Sadly, it's not quite that simple. In isolation, a P/E is just one piece of data that investors should evaluate.

As I wrote -- and comments on the article helpfully amplified -- P/Es are affected by market sentiment, because the numerator part of the ratio, the share price, reflects investor opinion rather than hard fact.

And opinions vary, even of relatively unloved shares. Looking at their P/Es in isolation, market sentiment seems to place a higher worth on Eurasian Natural Resources shares than on Barclays shares.

Really? I don't know about you, but given a choice, I'd rather put money into Barclays than Eurasian Natural Resources, prompted not least by concerns over Kazakh standards of corporate governance.

In other words, P/E is part of the picture, but not the whole jigsaw.

Finding out more
Where you go for the rest of the picture depends in part upon your agenda.

Value investing? Benjamin Graham's classic The Intelligent Investor is difficult to beat. Go for the updated edition with commentary by Jason Zweig, and read the foreword by Warren Buffett first.

Growth investing? Jim Slater's The Zulu Principle would be my choice.

Practical, hard-nosed company evaluation? As I've remarked before, I rather like Anthony Bolton's Investing Against The Tide.

Income investing? Save yourself the price of a book -- or a trip to the library -- and check out the FAQs on The Motley Fool's High Yield Portfolio discussion board.

Simple tests
Stripped to the basics, though, some common-sense tests quickly suggest themselves.

  • What are the trends? Are sales, earnings and dividends rising -- or static, or falling?

  • What is the share price history? And what lies behind any sharp falls?

  • Is the business model one in which you'd be happy investing? Is the market growing or shrinking? Does management seem credible? Is ownership highly concentrated, or foreign-dominated?

  • What do the annual report and accounts say? Net debt? Gearing? Pension deficit? How tangible are the assets? Etc., etc.

  • Finally, what does the "newsflow" say? Should investors have obvious concerns?

Reality check
At this point, let me share a secret with you. Apply those tests to pretty much any company in the FTSE 100, and you'll spot a red flag. Apply them to cheap-looking shares signaled by a low P/E, and you'll pick up several. There isn't, in short, a cheap-looking share that doesn't have any issues.

So it's all a question of balance, and judgment -- and risk-taking. How would you, for instance, weigh up these three shares?

  • Oil giant BP (ISE: BP.L) is a business trading on a prospective P/E of 7.0, well into "cheap" territory. So is it risky -- or simply unloved and out of favor? I take comfort from its ability to shrug off the events that have most recently defined it -- its problems in Russia and the Gulf of Mexico. The world's fourth-largest company in terms of revenues, according to the Fortune Global 500, BP is active in 30 countries worldwide, and won't, I reckon, go "pop" anytime soon.

  • Insurance giant Aviva (ISE: AV.L) , trading on a prospective P/E of 6.0, is another share priced well into "cheap" territory. Boardroom bust-ups, shareholder revolts, euro sovereign debt exposure, and a vast unfocused global business empire are just a few of its troubles. But as with BP, I'm happy to hold, reckoning that the company's 8% yield is reward for the relatively modest exposure. Even so, would I buy more? Not without a new CEO in place, and clearer signals regarding the turnaround strategy.

  • Mining giant BHP Billiton (ISE: BLT.L) , trading on a P/E of 9.3, is less obviously cheap -- but here, don't forget, we're talking the cyclical resources industry, with a potential China slowdown and global recession in the cards. At 4%, the prospective yield is higher than the FTSE's average of 3.7%. Undeniably cheaper than it has been -- BHP has underperformed the FTSE by 15% over the past year -- the risk investors are running is that it could get cheaper yet.

Follow the money
How about other cheap-looking shares? One U.K.-listed share -- not mentioned above -- has caught the eye of Warren Buffett, who has been buying on recent weakness, and now owns 5% of it.

Its name? Simply download this free special report from The Motley Fool -- "The One UK Share Warren Buffett Loves" -- to find out. Inside, you'll discover just why Buffett has invested over 1 billion pounds in this business, and why you could consider taking a stake, too.

Underperforming the FTSE by 20% over the past few months, it trades on a prospective P/E of 9.3 -- identical to BHP Billiton -- and offers a tasty 4.8% forecast yield. As I say, the report is free, and can be in your inbox in seconds.

Want to learn more about shares, but not sure where to start? Download our latest guide -- "What Every New Investor Needs To Know" -- it's free. The Motley Fool is helping Britain invest. Better.

More investing ideas from Malcolm Wheatley

The article When Is a Cheap Share Too Cheap? originally appeared on Fool.com.

Malcolm owns shares in BP and Aviva, but does not have an interest in any other shares named. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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