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 seemingly cheap stocks are everywhere. A quick screen finds more than 440 companies whose trailing-12-month price-to-earnings (P/E) ratios currently hit below 10 -- a figure that's about half that of the S&P. Filter that group again, this time looking for firms currently trading at least 20% below their 52-week highs, and you're still left with nearly 330 names -- a list that includes Devon Energy (NYSE: DVN  ) , DR Horton (NYSE: DHI  ) , Freeport-McMoRan (NYSE: FCX  ) , and recreation concern Brunswick (NYSE: BC  ) .

The likes of MittalSteel (NYSE: MT  ) , Phelps Dodge (NYSE: PD  ) , and Ford (NYSE: F  ) also sport sub-10 P/Es and prices at least 20% below their 52-week highs, too.

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

Cherry-picking rewards
OK, that question was a gimme. 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 to cherry-pick the very best bets from among the latter.

That's easier said than done, of course. For my money (and yours), discounted cash flow (DCF) analysis is the best 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; and the focus is certainly not on out-year earnings growth rates, which are notoriously difficult to predict with any degree of accuracy.

Instead, DCF fans total a company's cash from operations, subtract its capital expenditures, and make modest assumptions about earnings growth. They then apply a discount rate -- for example, the return they require, given the firm's business risk -- thus uncovering a company's intrinsic value. If the current share price falls below that number, the firm 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.

No muss, no fuss -- and no silver bullet
Despite being a huge fan of DCF, I realize there are other tools in the investing toolbox. Yes, DCF is a critical tool, to be sure. But it shouldn't be used to make a "buy" list -- just 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.

So 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 the 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.

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

Shannon Zimmerman is the lead analyst for the Fool's Champion Funds newsletter service and doesn't own any of the companies mentioned. Mittal Steel is an Inside Value recommendation. The Fool has a strictdisclosure policy.

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