Stocks: Cheap Is Relative

By | February 16, 2006

My friend asked me to tell him which is a good stock to buy for the long term. One of the companies I had in mind was Johnson & Johnson (JNJ). My friend said the stock price was too expensive, and asked for a cheaper suggestion. Too expensive??

I asked, “What about JDSU?” And he thought that JDSU is cheaper. But that’s dangerous thinking. What is cheap? Cheap is relative.

Would you pay $10 for an ordinary pencil and say it’s cheap? I’m sure you can still buy a lot of them. If you could buy the latest 42-inch LCD wall-mountable display for $500, would you say it’s expensive? I think comparing different companies and their stock prices is like comparing apples and oranges.

You may be paying under $3 a share for JDSU but you’re paying for a company that is losing money!! The forward P/E is 59, which means you’re paying 59 times as much for each buck the company earns. For JNJ, you’re paying $59 a share, or less than 15 times the forward P/E. In addition, JNJ pays out a dividend of $1.32 a share, or a yield of 2.30%. It is clear that JNJ is cheap, considering what you’re getting in return.

It is true that you can double your investments with JDSU, much like you can buy the $10 pencil and flip it for $20, but it is not without risk. You can make money as long as there are dumber people than you. As long as there’s a buyer willing to pay for it, you can flip the pencil up to as high $160. (In 1999, shell companies with no operations were trading for hundreds of dollars a share.) However, the efficient market theory states that the pencil will return to its true value over time, which is probably $1.50. This reminds you a lot about the crash of 2000, doesn’t it?

I don’t know about you, but if I were to invest for the long term, I would rather have my savings in a solid and stable company like JNJ yielding 2.30% a year plus the upside of capital appreciation. The company has $15 billion in cash, or about $5 a share and has profit margins of 20%. (Forbes sees JNJ as attractively priced.) It’s not hard to see how cheap JNJ is; you’re getting a great bargain here. I can leave my money in JNJ and sleep well at night, while you would worry about JDSU’s price volatility and wake up early every morning to make sure your money is still there.

Next time when you see a stock for under $3, look at the valuations of the company and see if it is worth it. Remember, cheap is relative to what you’re getting in return.

3 thoughts on “Stocks: Cheap Is Relative

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