Do Not Be Fooled By Stocks Under $5

Tracey Ryniec

Buying stocks under $5 is like buying a lottery ticket. It's the thrill of the "what if." Just because a stock is trading under $5 doesn't mean it's cheap and should be added to your portfolio.

This article was originally published by Zacks.com.

Buying stocks under $5 is like buying a lottery ticket. It's the thrill of the “what if.”

Take a stock like social gaming company Zynga. It went public in December 2011 and traded as high as $15.91 in early 2012 before the stock plunged due to disappointing earnings. Recently it traded as low as $2.10.

I know what you're thinking. That stock is “cheap,” right? But just because a stock is trading under $5 doesn't mean it’s cheap and should be added to your portfolio.

On the contrary. "Cheap" stocks could be the ultimate fake out for your portfolio.

“Cheap” doesn't mean you should own it

Many investors think a stock trading under $5 is “cheap.” In many investors' minds, a hot tech company that just went public only a year ago, like Zynga, can't simply “go away,” despite what we've seen with companies like Webvan and Pets.com during the dotcom boom.

After all, you can buy A LOT of shares for $2.10. All it needs to do is go to $4.20, and you double your money.

It's around $2. How much lower can it go? Why not take a chance?

It's easy to see how the gambling mentality takes over with low priced stocks.

Don't be fooled by low share prices

Don't get sucked into only looking at the price of the stock to determine if it is a bargain. The stock price is, really, irrelevant. It's all about the earnings in conjunction with the share price.

For example, storage maker Western Digital appears “expensive” as the stock trades at nearly $34 a share. But analysts estimate fiscal year 2013 earnings around $7.72 per share. That would give the company a forward price-earnings (P/E) ratio around 4.4. Now that is cheap.

Or consider IBM. Many see it as an “expensive” stock simply because it is trading around $189 a share. But if you look beyond the share price, you can find IBM's true value.

IBM is expected to produce double digit earnings growth this year and it has $11 billion cash on hand. It has a median forward P/E of 14 over the last 10 years, but is trading at just 12.7 times right now.

Based on its fundamentals, IBM is actually quite “cheap” despite the $189 share price.

Volatile markets create “cheap” stocks

The stock market has been on a roller coaster in the last year with uncertainty over the debt ceiling, the Eurozone debt crisis, the U.S. election and now the fiscal cliff. Several big name stocks have fallen under $5.

Just because a stock is low priced doesn't mean it's a value stock. Far from it. Buy earnings, not share price.

Look at P/E ratios and other value fundamentals first.

What will be the fate of investors who bought Zynga a few weeks ago at $2.10? The stock bounced back briefly but is getting hit again on news that the company's relationship with Facebook has changed, which has implications for the company going forward.

“Cheap” or low priced doesn't always equal “value.” Don't be fooled. Buy value first. Your portfolio will thank you.

Tracey Ryniec is Zacks' Value Stock Strategist and serves as editor in charge of the Value Investor. You can follow her on twitter at @TraceyRyniec.