This Is Wall Street's Biggest Flaw

What's a stock worth? Well, it depends on whom you ask.

People who believe in the efficient-market hypothesis will tell you that a stock is worth whatever the market says it is -- because the current price reflects everything that's known about the company. They'll also tell you that everyone participating in the market is a rational investor. By those definitions, no one can out-think the market, so we shouldn't bother trying.

But markets are often very far from rational -- witness the two bubbles and bursts of the past decade alone. This is largely the result of too many investors -- both amateur and professional -- making relative valuations to determine a stock's worth instead of evaluating a stock's intrinsic value.

See a problem here?
Outside of the stock market, in our daily lives, we make relative valuations all the time. When you're in the market for a house, for instance, you look at the recent sale prices of comparable homes in the neighborhood to determine how much you should bid. If the house you're looking at is priced below comparable homes, you could consider it undervalued.

Similarly, some investors determine a stock's worth by analyzing how it's trading compared with its peers. Let's say Company XYZ, which has strong margins and sales growth, is trading at 25 times earnings, but its competitors are trading at an average of 30 times earnings. By this logic, Company XYZ is undervalued relative to its peers, so it's an attractive stock.

If this doesn't scare you, it should. Why? Because what if all stocks are overpriced and should be trading at just 15 times earnings? You'll lose money along with everyone else when the market declines. Your stock wasn't undervalued at all.

You jump, I jump
According to Aswath Damodaran, a professor at New York University's Stern School of Business, relative valuation is "pervasive" on Wall Street. His data show that:

• Almost 85% of equity research reports are based on valuation multiples and comparables.
• More than 50% of all acquisition valuations are based on multiples.
• Rules of thumb based on multiples are not only common but are also often the basis for final valuation judgments.

Case in point: agriculture stocks in early 2008. Despite the fact that many of them, including Mosaic (NYSE:MOS), Potash Corp. (NYSE:POT), and Monsanto, were trading at stratospheric multiples, analysts found ways to justify buying them based on their valuations relative to each other and not their intrinsic value. Since June 2008, each of these companies has significantly trailed the S&P 500.

The problem with relative valuations is that they're based on what other people are doing, not on fundamentals, which is why I consider them to be Wall Street's biggest flaw. Rather than spend their time analyzing companies' true values and offering the market objective advice on when stocks should be bought and sold, analysts are engaged in a game of "Ring Around the Rosy" with each other -- all moving in the same direction until, you guessed it, they all fall down.

 Despite its failings, though, it's easy to see why relative valuation is prevalent on Wall Street.

• Using relative numbers, analysts can always find undervalued stocks, and portfolio managers can always justify being fully invested at all times. Because money managers make their bread by having assets under management, Warren Buffett aside, you won't find many of them saying, "I can't find anything to buy, so it's time to cash out."
• When your own performance is judged relative to other analysts' and portfolio managers', it's much safer to ride with the herd and make relative valuations. After all, you only need to be marginally better than your peers to become a red-carpet star in the financial media and ratings-agencies circles.
• If you use relative valuations and you're wrong, you'll have lots of company; on the other hand, if you deviate from the herd and are proven wrong, you're often wrong alone, and your time as an analyst will likely be short-lived.

To borrow a theme from many an after-school special, remember that what's right is not always popular, and what's popular is not always right. If the herd chooses to do something, it's going to do it. Whether it's the right thing to do is an entirely different matter.

The good news for us
The inherent volatility spawned by relative valuations creates opportunities for the business-focused investor with both patience and a strong stomach.

If you missed the best week to buy stocks back in March, don't fret. This recent rally won't last forever, and when the relative-valuation herd changes direction -- yet again -- you'll want to be ready to pounce on the opportunities to buy strong businesses at discount prices.

But how do you identify a strong company? Here's one tactic, offered by Ron Muhlenkamp of The Muhlenkamp Fund:

We begin to define a good company by looking at ROE or Return on Shareholder Equity ... ROE has been a stable statistic averaging around 13-14% since World War II. If we can find a company providing an ROE above 14% it is our first clue that we are dealing with a good company.

To get you started on your journey to find promising stocks, I've combined Muhlenkamp's advice regarding ROE with a debt-to-equity measure that suggests a healthy balance sheet.

Source: Capital IQ, a division of Standard & Poor's.

The road less traveled
Rather than follow the relative-valuation herd through another nauseating cycle of stock market elation followed by utter despair, take advantage of Wall Street's biggest flaw. Be a contrarian investor by patiently waiting for your opportunities to buy fundamentally strong companies. Yes, another opportunity will come again.

These days, patience is uncommon -- the average holding period for a stock on the NYSE is months, not years. Conversely, at our Motley Fool Stock Advisor service, led by Fool co-founders Tom and David Gardner, our biggest winners have been those we've held for more than five years, including the aforementioned Amazon.com, which David recommended in 2002 during the last bear market. In fact, Amazon remains one of David's "core" recommendations even today.

If you have the patience for business-focused investing, consider a free 30-day trial to Stock Advisor. There's no obligation to subscribe, so what do you have to lose?

Already subscribe to Stock Advisor? Log in at the top of this page.

Fool analyst Todd Wenning hopes everyone has a great fall. He does not own shares of any company mentioned. Amazon.com is a Motley Fool Stock Advisor pick. Microsoft is an Inside Value selection. The Fool has a solid disclosure policy.