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Value Investing Isn't Just Buying Cheap Stocks

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Value investing is one of the most intuitively appealing investment methods out there, and the reason is simple: Everyone loves a bargain. But just like smart shoppers ask tough questions about product quality before they jump on a sale-priced item, so too do value investors have to look closely at beaten-down stocks to decide whether they're truly good values or just cast-off clearance-rack companies with few future prospects.

The dangers of cheap stocks
If value investing were as simple as finding stocks trading at cheap prices, then it would be a trivial endeavor to make money. Even most beginning investors understand that low share prices by themselves mean nothing, as the total value of a company depends not only on the price per share of stock but also on the number of shares outstanding. A company with 1 million shares priced at $100 is worth the same as one with 100 million shares priced at $1, so gauging whether a stock is expensive or cheap based solely on share price doesn't give you enough information to draw valid conclusions.

Yet while most investors know to go beyond share price, they often get stuck at the earnings-multiple stage. The ratio of price to earnings is one of the favorites in all of value investing, as it attempts to tie the fundamental driver of stock prices to the prevailing current share price in the market. In general, the more net income a company is able to generate, the more valuable its shares should be.

Before you conclude that a stock is fundamentally cheap based on its P/E ratio, though, you need to look not just at its current earnings but also at its future prospects. Often, especially with cyclical stocks, you'll find that P/E gives you the exact opposite message that you'd expect. Consider these examples:

  • In the energy sector, oil giants ExxonMobil (NYSE: XOM  ) and Chevron (NYSE: CVX  ) both have attractive P/E ratios of around 10. Yet looking forward, analysts don't expect either company to produce a lot of profit growth, as both companies have had to work extremely hard to avoid massive output declines stemming from falling production levels from their respective oil-field assets. As long as Exxon and Chevron can acquire new properties with lucrative prospects, they'll be able to keep revenue up, but it's far from certain whether they'll succeed in finding new discoveries.
  • The cyclical trend is even more apparent in the refining industry. Marathon Petroleum (NYSE: MPC  ) and Phillips 66 (NYSE: PSX  ) have made huge share-price advances over the past year, as extremely wide spreads between crude oil prices in the U.S. and abroad have led to unusually high profits for refined-product sales. Now, though, analysts have increasingly concluded that a combination of rising costs, greater regulation, and narrowing spreads will lead to falling profits, making current P/Es based on trailing earnings artificially low if they turn out to be right.
  • You can find similar trends in other industries as well. Even in the traditionally high-growth tech industry, many sector giants have seen their P/E ratios plunge as earnings growth has slowed to a standstill. Dell (UNKNOWN: DELL.DL  ) is one of the most notable of these companies, with explosive growth during the 1990s having given way more recently to the PC bust and concerns about the viability of its business model going forward. Its share price has fallen so far that some value investors believe that the stock is a good prospect even with its business challenges, but failing to take projections of further headwinds into account when assessing the stock will certainly get you in trouble.

Conversely, you can sometimes find great values even among stocks with high P/E ratios. As long as earnings are growing quickly enough, a stock can justify an extremely high earnings multiple, at least for short periods of time. Obviously, paying too much for a high-growth stock doesn't make sense, but you can't focus on a given P/E level and have it work for every stock.

The right way to find value
Value investing is a useful tool for your arsenal of profitable investing methods, but it only works well if you can pin down what truly represents value. Trying to simplify value investing too much will get you into trouble, especially once you discover that many of the cheap stocks you run into in your research are cheap for very good reasons.

The best value investing approach is to choose great companies and stick with them for the long term. The Motley Fool's free report "3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.

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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.

  • Report this Comment On August 07, 2013, at 9:12 AM, cledrag wrote:

    Just a reminder, althought John Burr Williams talked about estimating dividends of the stock and discounting that to find the value of the security, that has been debunked. To value the security, value the entire business first. We should first find out and then estimate conservatively the future free cash generated by the whole business, value it, and then see if we are paying a reasonable price relative to value.

    Mr Charlie Munger once mentioned in an annual meeting that Buffett does not use the discounted cash flows approach either. According to Whitney Tilson's website which I highly recommend for your readings on Buffett and Munger:

    "If the future were predictable with any degree of precision, then valuation would be easy. But the future is inherently unpredictable, so valuation is hard -- and it's ambiguous. Good thinking about valuation is less about plugging numbers into a spreadsheet than weighing many competing factors and determining probabilities. It's neither art nor science -- it's roughly equal amounts of both.The lack of precision around valuation makes a lot of people uncomfortable. To deal with this discomfort, some people wrap themselves in the security blanket of complex discounted cash flow analyses. My view of these things is best summarized by this brief exchange at the 1996 Berkshire Hathaway annual meeting:

    Charlie Munger (Berkshire Hathaway's vice chairman) said, "Warren talks about these discounted cash flows. I've never seen him do one."

    "It's true," replied Buffett. "If (the value of a company) doesn't just scream out at you, it's too close."

    Marty Whitman, Mr Fan Jiang and Mr Seth Klarman approach valuation from the book value. Mr Bill Nygren approaches valuation from a more P/E approach. Mr Warren Buffett also, from the articles I have read and the feel I get from his letter to shareholders has an earnings approach as well. However, everyone has different methods. What is important is the margin of safety - which to me means, don't pay a price that requires everything to go right before the price paid is justified.

    e.g. If you project a revenue growth rate for the next 5 years of a company that ran into some earnings trouble in the short term at say 25%, which is very aggressive, and the value you calculated is about market price, I'll say there is no margin of safety because the probability of that happening is not very high and if it does not materialize, you didn't make a value buy.

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