Sure, we all feel like geniuses now, right? We stuck it out -- "it" being the worst economic crisis since the Great Depression -- and have now enjoyed fat and happy double-digit gains ever since the market hit bottom last March.
There's surely more to come, right? Right?!
Survey says ...
Who knows? We Fools pride ourselves not on making market calls, which are a great way to get slapped silly by the market's invisible hand. Instead, we take pride in our fundamental focus. Is a company's market share likely to shrink or grow? Has its management team delivered the goods over the long haul while deftly navigating both up markets and down? And in terms of valuation, does the firm's stock look like a blue-light special or a high-end luxury item?
In my experience, that last element -- valuation -- is often the toughest taco to crack. Some companies never look cheap, after all. Others that appear to be bargains may turn out to be value traps instead. Still, in general terms, one thing remains true: When a company sports moon-shot multiples, there's little opportunity to cushion the blow when the overall market hits the skids, or when the company itself blows up.
The higher they fly, the harder they fall
For example, take Google and Research In Motion. The former has gained more than 56% over the last year. The latter has increased by roughly 68% over that same stretch -- heady gains that ought to be understood in historical context.
Back in June 2008 -- shortly after reaching a fat and unhappy P/E above 60 -- RIM began a precipitous slide that saw the company's shares shed more than 50% of their value. Google suffered a similar fate when its above-40 P/E bubble burst around the same time.
Could investors have seen that coming? Not with perfect clarity, of course. But if they'd tuned into each firm's valuation, savvy investors might have dodged a bullet by taking gains, waiting for valuation gravity to work its magic.
Both companies have recovered since their respective sell-offs, and while each currently trades with far more modest multiples, they're not quite modest enough for my taste: As the history lesson I've just sketched illustrates, a little valuation discipline can go a long way. When an all-but-inevitable market pullback arrives, highfliers can be sitting ducks -- and future bargains, at least in relative terms.
Good companies. Lousy investments?
Along those same lines -- and following market-besting run-ups over the past 12 months -- Apple (Nasdaq: AAPL ) and Visa (NYSE: V ) could be cruising for proverbial bruisings, too. That goes double for Amazon.com (Nasdaq: AMZN ) , which sports a forward P/E of more than 45 times analyst earnings expectations for the current fiscal year. With its forward P/E of more than 46, meanwhile, VMware (NYSE: VMW ) appears similarly overvalued.
Last but not least: Yahoo! (Nasdaq: YHOO ) . Given its anemic revenue growth over the last three years -- not to mention its search market-share erosion -- is this a stock that ought to be priced (as it currently is) at almost 40 times earnings?
I don't think so, particularly not when there are plenty of long-haul overachievers trading on the cheap. Cases in point: Johnson & Johnson (NYSE: JNJ ) and Merck (NYSE: MRK ) , both of which sport P/E ratios below the broader market's.
The Foolish bottom line
There's more to uncovering values than just parsing price multiples. Separating truly cheap stocks from merely cheap-looking ones is a full-time job.
If you'd like some assistance when it comes to avoiding value traps, be sure to check out the Fool's Inside Value service, where the emphasis is squarely on rock-solid companies trading for a song. Click here to take the service for a completely free 30-day test drive.
This article was first published June 2, 2009. It has been updated.
Shannon Zimmerman runs point on the Fool's Ready-Made Millionaire and Duke Street services and doesn't own shares of any of the companies mentioned in this article. Google and VMWare are Rule Breakers recommendations. Apple and Amazon are Stock Advisor picks. Johnson & Johnson is an Income Investor selection. Motley Fool Options has recommended buying calls on Johnson & Johnson. The Fool has a strict disclosure policy.
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