How to Find True Value in Stocks

Everybody wants to find great stocks at bargain prices. But what exactly makes a stock a bargain?

If you're just getting started as an investor, you might come to the table with some preconceived notions of what makes a stock a good value. Many popular conceptions of value, however, are incorrect. Let's take a look at some of the most common mistakes that you can make in assessing value.

Forget share prices
The most obvious measure of value is a stock's share price. Unfortunately, comparing prices of different stocks is, in most cases, comparing apples to oranges.

Here's a case in point. Sirius XM (Nasdaq: SIRI  ) shares trade for around $1. Compared to most well-known stocks, that's low -- so low, in fact, that the company has faced ongoing threats of delisting from the Nasdaq stock exchange. But you may not realize that Sirius has a huge number of shares outstanding -- almost 6.5 billion, which is more than Coca-Cola or IBM.

By manipulating its capital structure, a company has a lot of control over its share price. Baidu (Nasdaq: BIDU  ) , for example, recently split its shares 10-for-1. The move came shortly after the Chinese online company announced yet another strong quarter for revenue and earnings, which often spurs companies with high-priced shares to do stock splits. Shareholders who formerly owned 10 shares of stock worth around $700 per share suddenly had 100 shares of stock worth $70 per share. But that didn't mean that the shares were suddenly a much better bargain; each post-split share represents a much smaller part of the same whole.

Capitalizing on value?
So if stock price doesn't work, how about market capitalization? At least that way, you get rid of all the share manipulation, as market cap -- the total number of shares outstanding multiplied by the share price -- puts a value on the entire company, not just single shares of it.

Even then, though, you might come to incorrect conclusions. Compare McDonald's (NYSE: MCD  ) and Burger King (NYSE: BKC  ) . The company behind the golden arches has a market cap around $73 billion, while the King weighs in at less than $2.5 billion. Does that mean Burger King belongs on your value menu?

By itself, market cap doesn't tell you much about whether a company is bargain-priced. Companies have wide differences in how much money they earn, which affects value. For instance, Burger King had net profit of around $200 million last year, but McDonald's earned $4.7 billion. That explains a lot of the disparity in their market caps, since the company with a market cap 25 to 30 times bigger earns around 24 times more in profit.

Looking for lows
Stocks hitting 52-week lows offer another tempting spot to seek value. After all, these stocks are a lot cheaper than they were earlier in the year, so they must be good values, right?

Sometimes, bottom-fishing does work. But just because a stock has fallen doesn't mean it won't fall further, or stay down for a long time. In March 2008, for instance, Citigroup (NYSE: C  ) hit a 52-week low of $18. The stock rallied for a while, as investors erroneously believed that the mortgage crisis would stay confined to subprime. But in the fall, it continued its slide, dropping to below $1 before rebounding to its current $4 level.

Similarly, stocks like General Motors and Enron all hit plenty of 52-week lows on their way down. As it turned out, they were never good values, even at ever-falling prices.

Tie to prospects
No, the only way to assess value is by linking share prices to some objective measure of the intrinsic value of a company. That's why so many people use metrics like price-to-earnings or enterprise value to free cash flow -- it draws a connection between the stock's price and its financial performance. Pulling in estimates of future profitability enhances valuation, although it also opens it up to the uncertainty inherent in making forecasts.

Finding cheap stocks is the goal of every investor, but don't get led astray. Make sure you're looking at the whole picture before you decide a stock must be a good value.

Shares of Goldman Sachs have hit bargain-basement levels lately. But Anand Chokkavelu has a stock that blows Goldman out of the water.

Fool contributor Dan Caplinger truly values purple-cow ice cream on a hot day over anything else. He doesn't own shares of the companies mentioned in this article. Baidu is a Motley Fool Rule Breakers recommendation. The Fool owns shares of Coca-Cola, which is recommended Motley Fool Inside Value and Motley Fool Income Investor. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy is a jewel of infinite price.


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  • Report this Comment On May 21, 2010, at 2:03 PM, nickolassc wrote:

    Read Graham's "The intelligent investor" or "Margin of Safety" for a good starting point. Look for companies have tangible assets that have real value, even if the company was to go bankrupt, those assets would still exist and still have some value. Then try to find a company that's at least 50% undervalued as its more likely to go up instead of down in the long run, hence the Margin of Safety. Invest in and be prepared to wait at least 5 years to expect a return, you are investing here, not speculating. Don't necessarily hold the company forever, have a sell criteria and when the sell criteria is met, go ahead and sell, and look for the next opportunity. If possible, always have cash on hand so you don't miss the opportunity for a good investment. I missed investing in YUM when it was under 30 because I was fully invested and didn't have the cash on hand to divert to that investment. The next thing I knew, YUM was pushing 45.

  • Report this Comment On May 23, 2010, at 8:01 AM, nopoverty wrote:

    Sunday: What hypocricy as regards your comments about Altria. If you don't want to smoke and I do, which I do not do any longer, it is of no interest to me or to you. Editorlize on the Editorial Page, not on the Finance Page. You invest in other people's habits good or bad, but I do not need your Koom bah lahing words to make you try to make me feel "Oh he's such a good person to try to end smoking..Koom bah lah.. Can't we all justh get along?" PUH TWO EE. Stick to finance.

    Let The View idiots and Larry Kingers suck up to the wimp crowd. Great article but bad choice of trying to justify what some would call your making money off the deaths and pains of others. TS. You wanna smoke, smoke. You don't wanna smoke , don't . Either way STFU about your personal stuff on the financial page. You can't have it both ways. You remind us of the guy who sold guns and ammo to the Gestapo, but had no blame in the deaths of those shot.

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