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 plentiful. A quick screen finds more than 4,300 companies trading at levels 20% or more below their 52-week highs. Filter that group again, this time seeking firms trading at least 25% below their yearly highs, and you're still left with more than 3,600 names -- a list that, as of Wednesday's market close, included Merrill Lynch (NYSE: MER), Kohl's (NYSE: KSS), and McGraw-Hill (NYSE: MHP).

Wyeth (NYSE: WYE) and AstraZeneca (NYSE: AZN) fit that profile, too. Meanwhile, Forest Laboratories (NYSE: FRX) and Advanced Micro Devices (NYSE: AMD) currently trade more than 35% below their annual high-water marks.

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, 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 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. 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 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. 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. In addition to a substantial price discount, you should also insist on top-shelf corporate management and gobs of free cash flow.

So, now what?
Here's the bottom line: The next time you're eyeballing a list of stocks 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, try 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. He doesn't own any of the companies mentioned. The Fool has a strict disclosure policy.