Market experts often say a stock looks ‘cheap' or ’undervalued'—here's what they actually mean

Investors, like shoppers, love a good bargain — and hate overpaying. That's why, in assessing potential investments, financial analysts often use the same language you might hear at an auction or on “Antiques Roadshow.”

Headlines will tell you that certain stocks are “cheap,” “undervalued” or “selling at a discount.” Others caution you that the market is “overpriced” or that a certain stock or sector is “historically expensive.”

“Probably the oldest tenet in investing is 'buy low, sell high,'” says Sam Stovall, chief investment strategist at CFRA. While a long-term, diversified approach is typically recommended for retail investors, the professionals are also attuned to the market's cycles, with different types of investments taking turns over- and underperforming, he says.

Investors' favorite way to determine who is in the lead “is by looking at the price-to-earnings ratio,” Stovall says.

Price-to-earnings, or P/E ratios, can tell an investor whether a stock looks overhyped or underloved by comparing it with its peers, the broader market or even its own history. Here's how the metric works.

How P/E ratios work

To determine how attractively a stock is priced, Wall Street analysts don't just look at the share price. Instead, they compare the price with one of the company's underlying fundamentals, such as sales, cash flow or, most popularly, earnings.

Because investors reap the rewards of corporate profitability over time, they're willing to pay more than the company brings in, in order to own a piece of it, in the form of stock. They can express just how much they're willing to pay by dividing the share price by the company's earnings per share to get the price-to-earnings ratio.

If a stock sells for $10 and is projected to realize $2 in earnings per share over the next 12 months, it has a P/E of 5.

In a vacuum, that doesn't mean much. But it's a great way to compare one investment to another, or to compare an asset or an index to a historical average.

For instance, stocks in the S&P 500 currently trade at 22.2 times year-ahead earnings, according to data from S&P Capital IQ. Over the past 10 years, the index has an average P/E of 19.1, meaning stocks are currently slightly pricey — a 16% premium to where they usually trade.

Looking for something cheap? Small-company stocks in the S&P MidCap 400 index have a P/E of 16.2 — a 13% markdown from its 10-year average of 18.6 and a 25% discount to the S&P 500.

Should you buy 'cheap' stocks?

P/E ratios are just one of many measures that investing pros use to determine how a company trades compared with its intrinsic value. The practice of buying stocks that trade cheaply compared with their underlying value is known as value investing — the core strategy of market luminaries such as economist Benjamin Graham and Berkshire Hathaway chairman Warren Buffett.

If a company has the ability to drive growing earnings over the long term, investors will eventually recognize the success and bid up the stock price, Buffett reasoned in his 1987 letter to Berkshire shareholders. If a stock trades cheaply because other investors don't recognize its potential, all the better, Buffett writes: “It may give us the chance to buy more of a good thing at a bargain price.”

Applying the concept more broadly, market watchers can divide stocks in an index, such as the S&P 500, into high-priced, fast-growing stocks — or “growth stocks” — and the cheaper “value stocks.”

Growth stocks, driven by the likes of high-flying tech firms, have been the better bet of late. Over the past decade, growth stocks in the S&P 500 have logged an annualized return of more than 15%, compared with a 12% return for value stocks.

Typically, the two investing styles take turns in the lead, says Charles Rotblut, vice president of the American Association of Individual Investors — even if growth has been leading the pack for quite some time.

“For value investors, it's felt like the pendulum has managed to dig itself into a ditch in the sand and hasn't managed to swing all the way back,” he says.

Historically, though, when investors have piled money into exciting new technologies, stock prices eventually fell and undervalued names returned to the fore, Rotblut says. It's unclear when that might happen, he says. But markets are cyclical — and history tends to repeat itself.

“We know over the long term, there are periods where growth outperforms and there's periods where value outperforms, so we do see that pendulum swinging back and forth,” he says. “I don't think this time is any different.”