How do you know if a stock is "cheap" or "expensive"?
Many investors see a stock that has fallen by 40% and think, "Bingo! It's on sale!"
But the truth?
Sometimes it's not a discount, it's a flashing warning.
So how do you really know if a stock is worth buying or just "junk in disguise"?
To understand if a stock is cheap or expensive, it's not enough to look at its price.
You need to understand what you're getting in return.
First step: multiples.
What are multiples anyway?
There are several types of multiples:
1. Price to earnings ratio (P/E): This is how much you pay for every shekel of earnings.
For example, if a stock trades at 100 NIS, and the company earns 5 NIS per share per year, the multiple is 20.
Meaning, you pay 20 times its earnings.
The higher the multiple, the more investors "believe" in future growth, and therefore are willing to pay more for current earnings.
2. Price/earnings to growth ratio (PEG): If P/E tells you 'how expensive,' PEG asks: 'expensive relative to what?'
What's the calculation? PEG = P/E divided by the annual growth rate. If PEG is below 1, it is sometimes considered relatively cheap, because you are paying little for a lot of growth.
3. EV/EBITDA: A multiple that also considers the company's debt and compares its value to operating cash flow.
This is an excellent tool for comparing companies with different capital structures, for example: one company with a lot of debt versus one without.
4. Price to sales ratio (P/S): If the company is not yet profitable but growing strongly, the price to sales multiple can help. How much do you pay for every dollar of sales? Good for comparison in startup companies or those with future profit potential.
Don't compare apples to oranges.
You shouldn't compare Tesla's multiples to those of a bank, for example.
Companies in different industries operate by different rules: A pharmaceutical company with a strong pipeline? A P/E of 30 sounds reasonable.
A retailer in a saturated market? Even a P/E of 10 can be excessive.
Beyond the numbers: quality assessment.
Even if the numbers look good, always look at the business itself:
Does it have a clear competitive advantage? Do customers return? Who leads the company? Is it investing in the future?
A truly cheap stock is not one that has fallen, but one that trades below its true economic value.
Look at the map above.
This is a heatmap of companies' price to earnings multiples, one way to check if the market is currently expensive or cheap.