Value or Value Trap?

As investors, we're all interested in uncovering those stocks that Mr. Market, for whatever reason, has mispriced. Ferreting out value before the "smart" money does, after all, is the name of the game if you want to beat the market.

Dirt cheap
Trouble is, seemingly cheap stocks are plentiful. A quick screen finds more than 350 companies whose trailing-12-month price-to-earnings ratios (P/Es) currently fall below 10 -- a figure that's about half that of the S&P. Filter that group further for firms currently trading at least 30% below their 52-week highs, and you're still left with some 160 names -- a list that includes the likes of Hovnanian Enterprises (NYSE: HOV  ) , Ford Motor (NYSE: F  ) , RadioShack (NYSE: RSH  ) , and Toll Brothers (NYSE: TOL  ) .

Meanwhile, Dow Chemical (NYSE: DOW  ) , Rite Aid (NYSE: RAD  ) , and Fresh Del Monte Produce (NYSE: FDP  ) also sport sub-10 P/Es and are at least 20% below their highs as I type.

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

Cherry-picking
OK, that was a not-so-tricky question. If you're reading this, I suspect you know very well that stocks frequently sport anemic multiples for good reasons. Your job as a savvy investor, of course, is to separate the duds from the keepers and then, beyond that, to cherry-pick the very best bets from among the latter.

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

Instead, DCF fans total up a company's cash from operations, subtract its capital expenditures, and make modest assumptions about earnings growth. They then apply a discount rate -- i.e., the return they require given the firm's business risk -- all toward the end of uncovering a company's intrinsic value. If the current share price falls below that number, the firm may be worth looking into. If not, they go looking elsewhere. Even during periods of market froth, after all, it's still possible to uncover values.

No muss, no fuss -- and no silver bullet
As big a fan of DCF as I am, it's really just one tool in the toolbox -- a critical tool, to be sure, but one that should be used not to make a "buy" list but rather a short list of prospective investments for further research.

This is precisely how Philip Durell works on the Fool's Inside Value newsletter service. In terms of strategy, Philip is on the lookout for companies trading well below his conservative estimate of intrinsic value. In a nutshell -- and as Philip put it when Inside Value made its debut back in August 2004 -- his approach to stock selection boils down to "scouring the market for that company trading for 50 cents on the dollar." And these companies, by the way, are far from value traps. Indeed, in addition to a substantial price discount, Philip also insists on top-shelf corporate management and gobs of free cash flow.

Now what?
With that as a backdrop, here's the bottom line: The next time you're eyeballing a list of stocks with discounted P/Es that are trading near 52-week lows, dust off your DCF calculator to see whether your prospects are worth prospecting. And in the meantime, if you'd like a peek at some of Philip's best bargains or access to the easy-to-use DCF calculator his service provides, just click here for a free 30-day guest pass to Inside Value.

Shannon Zimmerman is the lead analyst for the Fool's Champion Funds newsletter service and doesn't own any of the companies mentioned. Dow Chemical is a Motley Fool Income Investor recommendation. The Fool has a strict disclosure policy.


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