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? 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 3,200 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 2,500 names -- a list that, as of Monday's market close, included Broadcom (Nasdaq: BRCM) and Hershey (NYSE: HSY).

SanDisk (Nasdaq: SNDK) is down more than 35%, and Cognizant (Nasdaq: CTSH) isn't far behind. Meanwhile, D.R. Horton (NYSE: DHI) and Coldwater Creek (Nasdaq: CWTR) currently trade more than 60% 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, but discounted cash flow (DCF) analysis is one of the best ways to proceed. With DCF, your primary focus is on the real cash a company generates, not earnings, which are all too often managed to meet the Street's expectations. 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 it's still possible to uncover values in both bull and bear markets.

No muss, no fuss -- and no silver bullet
Despite being a huge fan of DCF, I realize there are other weapons in the investing arsenal. 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 estimate of intrinsic value. As Philip has said, 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, a solid balance sheet, 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 is adapted from a Shannon Zimmerman article originally published Feb. 28, 2006. It has been updated.

Rich Greifner owns plenty of stocks trading off their 52-week highs but none of the companies mentioned in this article. The Fool has a strict disclosure policy.