The Right Way to Be Wrong

Chicken Little is making a fortune shorting the stock market right now. Since 2008 rolled in, the market has dropped some 5%. Add to that recession fears, further housing troubles, and a slowing jobs picture, and panicked investors believe the pain may not stop.

The beautiful part about panic, though, is that it creates tremendous bargains. Stocks can get so cheap, in fact, that you can be wrong in your value estimates and still profit. Take, for instance, Home Depot (NYSE: HD  ) . The housing meltdown has absolutely destroyed this company's stock. It's as if the market expects the housing market to never recover.

Embrace the fear
At the same time, though, analysts' five-year-growth estimates for the company clock in north of 12%. Clearly somebody's wrong -- either the market is unreasonably scared or the analysts have once again botched their projections. (Incidentally, it wouldn't be the first time for either.)

Of course, there's a third option: Everybody's wrong -- both the market and the analysts. In truth, that's probably what will play out in the end. That kind of scenario is exactly where you as an individual investor can profit.

Cut back and win
One of the biggest determinants of a company's future value is its rate of growth. A faster-growing company earns a premium valuation, while a slower-growing firm will trade at lower multiples. Even a modest change in growth can have a big impact on the value you estimate for a company:

Company

TTM
Earnings

5-Year Analyst Growth
Estimate

Value if
Estimates
Are Correct

Value if
Estimates
Are 25% Too Aggressive

General Electric (NYSE:GE)

$2.15

11.2%

$44.87

$38.30

Google (NASDAQ:GOOG)

$12.78

34.4%

$952.54

$601.68

Home Depot

$2.40

12.3%

$53.24

$44.78

Linear Technology (NASDAQ:LLTC)

$1.41

15.6%

$37.76

$30.34

Oracle (NASDAQ:ORCL)

$0.91

15.2%

$22.41

$19.27

AT&T (NYSE:T)

$1.91

9.0%

$33.27

$31.10

Walgreen (NYSE:WAG)

$2.06

13.4%

$45.87

$40.41

Dollar values per share. Estimated growth from Yahoo! five-year composite analyst estimates.

The swings can be dramatic. That's a pretty big change caused by a few percentage points of lower growth. 

Use it to your advantage
By dialing down your expectations just a bit, you'll come up with a lower price you'd be willing to pay to own the stock. If the market still offers you a discount below even that lowered estimate, then it just might be time to buy. After all, an even lower price gives you even more breathing room to be wrong and still make money. 

That breathing room can come in handy. The wild swings in value calculated above came from just reducing expected earnings growth by a fourth. If there's a recession, earnings will likely decrease even more. If even your lowered estimates turn out to be too high for reality, you're going to want all the breathing room you can get. Check out the breathing room (or lack thereof) priced into those same companies:

Company

Recent
Market
Price

Value if
Estimates
Are 25% Too
Aggressive

Breathing Room
if There's a
Stumble

Home Depot

$24.74

$44.78

44.8%

Walgreen

$34.23

$40.41

15.3%

General Electric

$35.40

$38.30

7.6%

Linear Technology

$29.74

$30.34

2.0%

Google

$631.68

$601.68

(5.0%)

Oracle

$21.15

$19.27

(9.7%)

AT&T

$39.16

$31.10

(25.9%)

How you profit
At these prices, Home Depot is already priced for terrible things to come. If those nasty things do happen, its already-discounted price should help protect your investment. Of course, you could have been wrong by assuming Home Depot would grow slower than the analysts' estimates. In that case, it simply has all that much more room to grow to reach its true value.

Lower downside risk. Better upside potential. That's the benefit of finding companies that trade well below lowered expectations. And it's how we look for investments at Motley Fool Inside Value. If you're ready to turn your incorrect valuations into an investing advantage, then join us free for 30 days.

At the time of publication, Fool contributor and Inside Value team member Chuck Saletta owned shares of General Electric. Home Depot is an Inside Value selection. The Fool has a disclosure policy.


Read/Post Comments (0) | Recommend This Article (18)

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: 557950, ~/Articles/ArticleHandler.aspx, 10/26/2014 4:47:00 AM

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 1 day ago Sponsored by:
DOW 16,805.41 127.51 0.76%
S&P 500 1,964.58 13.76 0.71%
NASD 4,483.72 30.92 0.69%

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

10/24/2014 4:00 PM
GE $25.64 Up +0.20 +0.79%
General Electric C… CAPS Rating: ****
GOOGL $548.90 Down -4.75 -0.86%
Google (A shares) CAPS Rating: ****
HD $94.99 Up +0.19 +0.20%
Home Depot CAPS Rating: ***
LLTC $40.89 Down -0.03 -0.06%
Linear Technology CAPS Rating: ****
ORCL $38.73 Up +0.50 +1.31%
Oracle CAPS Rating: ****
T $33.87 Up +0.21 +0.62%
AT&T CAPS Rating: ***
WAG $62.65 Up +0.58 +0.93%
Walgreen Company CAPS Rating: ****

Advertisement