Ideally, investors want to buy when stocks are at their lowest point and sell when prices have peaked. Identifying when stocks are expensive or cheap involves deciding whether shares are undervalued or overvalued. While there are some formulas that investors can use to measure a stock price relative to certain parameters, there is no way to be sure that a price will attain that valuation. Nonetheless, investors can look for some signals that might suggest when stocks are overpriced or a bargain.
When a stock is considered expensive, it is viewed to be priced too high relative to its growth or competitive position. Investors might be buying shares based on reasons unrelated to a company's financial picture, such as emotion or rumors. Cheap stocks are deemed to be priced too low based on their current or potential financial potential. Sometimes investors fail to give a company enough credit for its accomplishments.
Investors can determine whether a stock is expensive or cheap by calculating a price-to-earnings, or P/E, ratio. This calculation can be approached in several ways, and results vary based on the components used, according to "USA Today." A common P/E ratio divides a stock's current market value, or price, by the average earnings per share in the previous year. The result indicates the way that the markets are valuing a stock. The higher the P/E ratio, the more investors are willing to pay. A low P/E ratio suggests that investors have little conviction to own shares.
Sometimes it's possible to determine if a stock is trading expensive or cheap by comparing trading activity with some other industry benchmark. In the commodity sector, for instance, stocks that develop resources tend to mimic trading patterns in the actual commodity itself. In 2012, when the price of gold was setting records, the stocks of the companies that mine gold were not. In the four-year period ending in 2012, the price of gold increased some 80 percent, while the increase in gold stocks paled in comparison. As a result, gold stocks were largely considered inexpensive, according to an article in "Barron's."
Sometimes it's not just an individual stock that is expensive or cheap but the overall markets that appear to be overvalued or undervalued. In August 2012, companies were falling short of earnings expectations and reporting disappointing financial outlooks for the remainder of the year. Nonetheless, individual stocks and broad market indexes were still rising, which -- according to MSN Money -- made the stock market as a whole expensive. When stocks are not trading on their own merits, it is difficult to identify financially sound companies that are trading at a cheap price.
Geri Terzo is a business writer with more than 15 years of experience on Wall Street. Throughout her career, she has contributed to the two major cable business networks in segment production and chief-booking capacities and has reported for several major trade publications including "IDD Magazine," "Infrastructure Investor" and MandateWire of the "Financial Times." She works as a journalist who has contributed to The Motley Fool and InvestorPlace. Terzo is a graduate of Campbell University, where she earned a Bachelor of Arts in mass communication.