The Most Precise Way to Get It Wrong

Like many Americans, I spent most of New Year's Day sprawled out on my couch watching college football bowl games. There were few good takeaways from the day, as my beloved Penn State Nittany Lions lost to Florida and fellow Big 10 powerhouse Wisconsin fell to scrappy TCU.

However, during one of the games, as the refs pulled out the chains to measure for a first down, my sister offered a very insightful observation.

"This is ridiculous," she chuckled, "they make a guess at where to put the ball down and then measure it down to the inch."

Amazingly, that had never occurred to me. Every time those chains were solemnly hauled out during a football game, I was too focused on the outcome of the measurement to ever consider whether the measurement made any sense. And, fact is that it doesn't. As long as the refs are spotting the ball based on a best guess, they might as well just eyeball whether it's a first down rather than go through all the measuring hoopla.

Yet, the measurement is never questioned. Why? Because we love the illusion of precision.

It's not just a football thing
Our attachment to pretending that we're being precise certainly doesn't stop at football. When I'm cooking pasta, I dutifully set the timer for exactly the time that the box lists for al dente pasta, ignoring the fact that different pot materials, stove quality, elevation, and a host of other variables mean there's no way the cooking time on the box is the exact one for my cooking conditions.

Many investors fall into the same trap. Whether they're fundamental investors trying to use financial statements to calculate a fair value for the stock or technical analysts reading the tea leaves to figure out what price the stock will be at six months or a year from now, we hear all the time that such-and-such stock is worth some specific value. But, of course, it's all bunk.

A valuation built on fundamental analysis often relies on projections of future results, something that is inherently unknowable. Yet analysts nevertheless take stabs at what a company will earn one, five, or even 10 years down the road and come up with a precise numerical valuation -- sometimes down to the cent -- on what a stock is worth.

Technical analysis is even worse. It often comes up with similarly precise results, but it bases those on past wiggles of the stock price, rather than financial performance and other fundamental factors.

Getting the exact first down
They have it easier in football. If officials weren't afraid of having fans fall asleep during the games, there's actually an easy fix for the measurement issue. With an array of cameras focused on the game, they could carefully study replays after every play to determine the exact location where the ball should be placed. They could continue to pull out the chains to measure when necessary, but with current technology they could probably also rig up some sort of laser measurement system that would do all the work for them.

For investors, though, there isn't such an elegant (if stultifying) solution. So do we just give up trying to value stocks altogether? Hardly! For pretty much of the best investors, the basis of investing lies in buying securities at prices that are below their true value. But how are we supposed to do that if we can't precisely measure their actual worth?

Not surprisingly, Warren Buffett once again has the answer. During the 2007 shareholder meeting for Berkshire Hathaway (NYSE: BRK-B  ) , Buffett quipped:

If we see someone who weighs 300 pounds or 320 pounds, it doesn't matter -- we know they're fat. We look for fat businesses.

In other words, the answer isn't to give up on doing the analytical work. Rather, it's to know the limits of that work and not worry about the fifth decimal place.

Fat stocks
In recent months, I've shared some of my own analytical work as I've looked at the valuations for many stocks. A handful of the stocks that I've reviewed seem like good candidates for the "fat stock" label.

Company

Current Price

Current Price-to-Earnings Ratio

Valuation Date

Comparable Company Analysis Result

Discounted Cash Flow Result

Abbott Labs (NYSE: ABT  ) $48.17 15.9 8/4/2010 $62 $67
NVIDIA (Nasdaq: NVDA  ) $19.33 46.1 8/9/2010 $13 $15
Johnson & Johnson (NYSE: JNJ  ) $63.21 13 8/24/2010 $58 $82
Intel (Nasdaq: INTC  ) $20.77 11.3 11/2/2010 $25.50 $25
AT&T (NYSE: T  ) $29.15 8.4 12/10/2010 $32 $36

Sources: Capital IQ, a Standard & Poor's company, and author's calculations.

Right off the top, NVIDIA jumps out in this group. Back in August when I did my valuation work, the stock was trading at less than $10 per share -- a good deal lower than my valuation estimates. At the time, it didn't really matter whether NVIDIA's stock was worth $13 or $15 exactly -- the key was that it appeared to be worth something more than $10. And since then the market appears to have concurred (and then some).

While the opportunity may have disappeared with NVIDIA, Mr. Market hasn't been as quick to reevaluate these other stocks. But it's a similar story with the rest of the pack. Pinning down an exact valuation isn't important; instead, investors should focus on getting comfortable that today's price doesn't reflect the company's full value. Abbott Labs, for instance, may not be worth exactly $62 or $67 (heck, it could be worth more), but what seems to be clear is that $48 is a bargain.

There isn't a single way to find these fat stocks, either. Last month, I compiled a list of stocks that looked like bargains based on a share price that was a discount to the company's tangible equity. The list included Marshall & Ilsley (NYSE: MI  ) , whose share price was confirmed as a bargain when Bank of Montreal swooped in to buy the bank. But there are still other opportunities out there like Genworth Financial (NYSE: GNW  ) , which is still priced at just half of its tangible equity.

To be sure, this isn't a rallying cry to be sloppy and careless with your investment work. As investors, it's important that we are careful and diligent in our research. However, it's very important to keep in mind when we're working with precise, verifiable data and when we're working with estimates and best guesses so that we don't confuse the two and pretend to have a better crystal ball than we actually do.

If you're looking for something verifiable, dividends may be your answer. And my fellow Fools have compiled a list of their favorite 13 dividend stocks in this free report.

Berkshire Hathaway and Intel are Motley Fool Inside Value recommendations. Berkshire Hathaway and NVIDIA are Motley Fool Stock Advisor recommendations. Johnson & Johnson is a Motley Fool Income Investor recommendation. The Fool owns shares of and has bought calls on Intel. Motley Fool Options has recommended buying calls on Intel. Motley Fool Options has recommended a diagonal call position on Johnson & Johnson. The Fool owns shares of Berkshire Hathaway and Johnson & Johnson. Motley Fool Alpha owns shares of Abbott Laboratories and Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Fool contributor Matt Koppenheffer owns shares of Berkshire Hathaway, Abbott Labs, Intel, Johnson & Johnson, and AT&T, but does not own shares of any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 10, 2011, at 8:38 PM, 1caflash wrote:

    I'm a bit Conservative, but You will not find me waving signs at a Political Rally; instead, on Monday 1-10-2011, I joined the "T" Party and Bought shares of AT&T. Competition is Great for Everyone! If T's shares get slammed, then I'll Buy More. You do not run away scared when a fine, consistent Dividend-Payer's Stock Price becomes a Better Bargain. Embrace it.

  • Report this Comment On January 10, 2011, at 8:49 PM, TMFKopp wrote:

    @1caflash

    "I joined the "T" Party and Bought shares of AT&T."

    Haha! Good one!

    Matt

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