Value or Value Trap?

As investors, we're interested in uncovering stocks that Mr. Market, for whatever reason, has mispriced. Hey, we're opportunists, right? There's some skill involved, too. After all, ferreting out value before the "smart" money does is the name of the game if you want to beat the market.

Dirt cheap buys
The trouble is that, these days, seemingly cheap stocks are plentiful. A quick screen based on Friday's closing prices finds more than 7,000 companies trading at levels 50% or more below their 52-week highs. No surprise, perhaps, until you look at some of the companies that make that unkind cut. Boeing (NYSE: BA  ) , Lowe's (NYSE: LOW  ) , PotashCorp (NYSE: POT  ) are in the mix, for example, stalwarts that have delivered the market-beating goods for shareholders over the long haul and whose current P/Es fall below that of the broader market.

And if you’re looking for seemingly cheap growth plays, consider that Schlumberger (NYSE: SLB  ) and Texas Instruments (NYSE: TXN  ) are in the half-price club too -- despite juicy earnings growth forecasts over the next five years. Corning (NYSE: GLW  ) and Best Buy (NYSE: BBY  ) also strike cheap-growth profiles.

 So, should you head to your favorite discount brokerage and start placing orders ASAP?

Cherry-picking rewards
OK, that question was a gimme. If you're reading this, you probably know very well that stocks frequently trade well off their highs for good reasons. Your job as a savvy investor is to separate the keepers from the duds -- and, from there, pick the very best bets.

That's easier said than done, of course. For my money (and yours), discounted cash flow (DCF) analysis is a great way to proceed. With DCF, your primary focus is on the real cash a company generates, not earnings, which are all too often stage-managed for the Gucci-loafer set on Wall Street. Your focus is certainly not on out-year earnings growth rates, which are notoriously difficult to predict with any degree of accuracy.

Instead, DCF fans will total a company's cash from operations, subtract capital expenditures, and make modest assumptions about earnings growth. They then apply a discount rate -- for example, the return they require, given the company's business risk -- thus uncovering a company's intrinsic value. If the current share price falls below that number, the company may be worth looking into. If not, DCFers will look elsewhere. Remember that even during periods of market froth, it's still possible to uncover values.

Despite being a huge fan of DCF, I realize there are other tools in the investing toolbox. Rich profitability metrics -- such as return on assets (ROA) and return on equity (ROE) -- are essential, too, as is a management team's ability to delivery market-shellacking returns for their shareholders over the long haul as well. Past performance is no guarantee of future results, of course, but as a yardstick for gauging executive-suite acumen, it comes in mighty handy.

In other words, the next time you're eyeballing a list of stocks trading near 52-week lows, be sure to investigate their seemingly discounted multiples relative to their forward-looking prospects and historical success.

So, now what?
We use all of these tools at Ready-Made Millionaire, the real-money investment service I head up. The Fool has plunked down a million bucks on our Ready-Made lineup, which includes a clutch of great companies trading at what I believe is a tremendous discount relative to their value. This set-and-forget portfolio is designed to beat the market over the next three to five years and beyond. All told, our approach at Ready-Made is probably best characterized as "growth at a reasonable price" or, as the cool kids like to call it, GARP.

We'll be opening the doors to new members next week, and between now and then, you can download -- for free -- our 11-Minute Millionaire special report, a Foolish write-up designed to help you make the most of up markets and down. Just click here to snag the report and learn more about Ready-Made Millionaire.

This article was originally published on Feb. 28, 2006. It has been updated.

Shannon Zimmerman is the lead analyst for the Fool's Ready-Made Millionaire newsletter service. Best Buy is a Motley Fool Stock Advisor and Inside Value recommendation. The Motley Fool owns shares of Best Buy. The Motley Fool has a strict disclosure policy.


Read/Post Comments (0) | Recommend This Article (12)

Comments from our Foolish Readers

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.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 830892, ~/Articles/ArticleHandler.aspx, 12/18/2014 4:16:56 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Today's Market

updated Moments ago Sponsored by:
DOW 17,776.80 419.93 2.42%
S&P 500 2,061.23 48.34 2.40%
NASD 4,748.40 104.08 2.24%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

12/18/2014 3:59 PM
BA $125.69 Up +0.63 +0.50%
The Boeing Company CAPS Rating: ****
BBY $38.47 Up +1.00 +2.67%
Best Buy CAPS Rating: *
GLW $22.18 Up +0.89 +4.18%
Corning CAPS Rating: *****
LOW $66.61 Up +0.66 +1.00%
Lowe's CAPS Rating: ****
POT $35.27 Up +0.02 +0.06%
PotashCorp CAPS Rating: ****
SLB $84.20 Up +1.32 +1.59%
Schlumberger CAPS Rating: *****
TXN $54.47 Up +0.97 +1.81%
Texas Instruments,… CAPS Rating: ****

Advertisement