How to Spot a Real Bargain

To know whether a stock price plunge offers opportunity, you need to look at your own investing style, evaluate the reason for the drop, compare the new price with your valuation of the company, and decide whether the possible return offers sufficient reward for the risk. These elements are all mixed in, but they need to be addressed before you can determine value.

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By Tom Jacobs (TMF Tom9)
January 7, 2002

Who among us has not watched a stock we don't own plummet, sigh with relief, but at the same time heard a little voice ask, "Is there a value here?" Stock prices over the long term may be efficient, but in the short term, herds can move stock prices up and down way out of proportion to the effect of any news on a business's underlying value. These can be rare opportunities to obtain shares at a discount to that value.

Unfortunately, no battered stock brandishes a flashing red sign announcing, "I'm a deal!" in much the same way that dates' lapels don't announce "I'm not a psycho" or bosses' "I'll treat you right." Take a recent example: ImClone Systems (Nasdaq: IMCL) announced on Dec. 28 that the FDA would not accept its application for review for its proposed colorectal cancer treatment, Erbitux. From its Dec. 27 close through Jan. 3, ImClone stock dropped 29%. All told, the stock plunged 41% from its $73.83 52-week closing high on Dec. 6 to last Friday's $43.39 close, and it had fallen another 15% or so by mid-day today. Discount pricing, or a bright red Stop sign?

To decide whether you can take advantage when a stock price plummets, there are four main questions. First, what kind of an investor are you? Second, does the price drop have to do with the business? Third, how does the news change your estimate of the company's value, if at all? And finally, does that estimate mean that a purchase of the shares at current prices offers you sufficient return for your risk?

These questions aren't necessarily discrete and don't have to be answered in this order, but I'll go through them that way for convenience. Today's column scopes out the first two.

What kind of investor are you?   
If you are an investor in individual stocks, you may do it in several ways. One common technique is through dollar-cost averaging -- a key feature of DRIP investing (dividend reinvestment plan). You may choose to invest more or less fixed amounts in a stock on a regular basis, and select businesses with an extensive track record of growing profits and free cash flow. Stock price plunges matter only to you because your regular additional purchases buy more shares and lower your average purchase price. You are highly unlikely to have your eye on an unprofitable, development-stage company like ImClone. 

A better place for your money?
Who might profit from paying attention to drops? Some investors who have the bulk of their money already invested, perhaps with some cash sitting on the sidelines. They buy to hold, and sell rarely, only when they have a better place for their money.

They have stocks they're dating, kept on a watch list before the watcher walks the aisle. Perhaps there's an excellent business that meets certain investing criteria, except valuation. At its current price, it doesn't offer the investor the chance to make enough money versus other places for that money: "Gee, I'd sure like that shiny new TechWonder (Ticker: WOW), but it's selling for 1000 times forward vapors!" Or, you think ImClone's Erbitux has potential to create future profits for the company, but you doubt that even ImClone's share of potential billions in Erbitux sales would provide meaningful investing rewards for shares bought at its current price.

This is the kind of investor who may wish to take advantage of a sudden stock price drop that may create value. Someone who has ImClone on a watch list has just found it 29% or 41% cheaper (and more today). The next step is to examine what caused the dramatic plunge and evaluate its effect on business.

Is it business news or noise? 
For example, let's say that shares move dramatically in sympathy with the broad market averages, such as the fall after Sept. 11. If nothing has happened to change business prospects, and you already have performed a valuation of the company, you know pretty quickly whether you have a bargain.

Another example from the post-Sept. 11 period is Check Point Software (Nasdaq: CHKP), whose shares tanked much deeper than the Nasdaq composite average, without any company specific news, perhaps because it's based in Israel. If you had a valuation of the business handy, and you thought that a security software plan with worldwide sales might have contingency plans for its operations, the herd might have provided you with an opportunity to obtain shares at a discount.

Some business-related price drops are easy to evaluate, such as the category of rare -- we hope -- reports that top management has raided the company treasury and absconded to a nation lacking an extradition treaty with the U.S., a company's financial reports have been lies, or, say, a debt-rating outfit has lowered the boom on a debt-laden company's owings. These bring pain to current shareholders, and sighs of relief to those who may have had the stocks on a watch list.

When the FDA calls the shots
But sometimes negative business reports are not so black-and-white. Take ImClone's Erbitux news. Any drug maker -- whether established or up-and-coming -- faces the possibility that the FDA won't accept an application for a new drug. Even after review of an accepted application, the FDA might say that it needs more data to evaluate the application or deny approval altogether. This requires the company to run more expensive human trials or give up development. It's part of the business, and investors in drug companies must expect a certain percentage of drug candidate delays or failures.

All of the established large drug companies not only have other health care businesses besides prescription drug making, but they have many drug candidates in their development pipelines. The delay or failure of one candidate may not be good, but it goes with the territory. Other candidates will presumably succeed, according to the percentages. But ImClone is no such company. It has no drugs on the market, no profits or free cash flow, and $31 million in trailing-12-months revenue. Despite other drugs in development, Erbitux -- for its many proposed cancer uses -- simply is the company's business prospect.

The FDA action either delays approval some months (ImClone needs only a paper quick fix), delays approval a few years (new trials are required to provide more data) putting off revenues and giving competition an opportunity to catch up or get ahead, or means Erbitux won't be approved for colorectal cancer or possibly any other indication. Each scenario means dramatically different things for ImClone's value and potential return. Uncertainty about Erbitux's future may have led the herd to overreact and create an opportunity to obtain its shares at a value. But that same uncertainty about Erbitux makes valuing the company a riskier proposition, too. Catch-22.

That brings us to valuation and potential return. How do you assign a value so that you know whether the plunge has created a bargain, and how much of a potential return do you need to account for investment risk? Books on these subjects fill library shelves and a gigabyte of The Motley Fool website storage, and next Monday's column will provide a road map. Then, the Monday after Martin Luther King Day, I'll attempt a full-blown valuation of ImClone Systems to tie up all these four steps in looking for value.

In the meantime, I will make offerings to the spreadsheet gods.

Have a most Foolish week!

Tom Jacobs (TMF Tom9) apologizes to The Beatles for "Eight Loads A Week," his hymn of praise for his new washer/dryer. At press time, he owned no shares in companies mentioned in this story. To see his stock holdings, view his profile, and check out The Motley Fool's disclosure policy. Tom reserves the right to be wrong, stupid, or foolish (small "f"). So there.