What Are Your Stocks Really Worth?

In good stock markets, everyone's a genius. But at times like these, you can easily tell the self-proclaimed stock know-it-alls from those who have real experience and expertise.

To make smart decisions with your money when mayhem is running rampant throughout the investing world, having a fundamental understanding of what your stocks are worth is priceless. Without that, there's nothing to anchor your opinions about investments you've already made -- and you won't have a clue whether current events have really had as big an impact on a company's intrinsic value as its share declines suggest.

Putting value on your side
When markets crash, you can't count on current stock prices to tell you the truth about the real value behind your shares. In the panic to sell at any price, sellers throw fundamentals out the window. Although the resulting declines hurt your portfolio value in the short run, they also open the door to unprecedented opportunities to grab once-in-a-lifetime bargains on shares.

If you don't know what your stocks are really worth, though, then you won't find it as easy to cash in on those opportunities. Consider a simple valuation method such as the popular price-to-earnings (P/E) ratio. As you'd imagine, after weeks of steep price drops, many companies have seen their P/E ratios plummet. Here's a sample of S&P 500 stocks that have seen substantial drops:

Source: Yahoo! Finance.

Needless to say, if you thought these companies were attractive before, you're positively drooling over them now. And even some stocks that looked pricey before the crash have become a lot more reasonable.

Where's the E?
The problem with P/E ratios is that while the price is always available, figuring out which earnings figures to use is trickier. Past earnings results have the benefit of being fixed, absent accounting revisions. But they also can mislead you -- especially at times like these, when there's a lot of uncertainty about the future direction of the overall economy, let alone particular sectors and industries. A stock with a P/E less than 10 can be extremely overpriced if company earnings are certain to decline substantially over a sustained period.

That's why backstopping simple measures like the P/E ratio with other valuation methods can make the difference between making a winning stock pick and making a big mistake. Here are a few other ways to value stocks that you should consider:

• Make them show you the money. Thanks to cryptic accounting rules, earnings figures can mask a company's true financial condition. But it's hard to hide actual cash in a business. That's why basing your stock valuations on free cash flow -- a company's total revenue less its spending on capital expenditures -- can give you a clearer idea of whether a company has a steady stream of income to depend on. When it's hard to borrow, free cash gets even more important.
• Better yet, make them give you the money. If your stocks pay dividends, you know they've got at least enough cash to pay them out -- and you can also value your shares based on how much you think you'll get in dividends in the future. Although old-style valuation methods based on dividends have their shortcomings, they can at least give you an idea of whether you're in the right ballpark.
• Know your industry. Certain sectors of the market have their own special valuation rules. For instance, financial stocks have traditionally had lower P/E ratios than most stocks in other industries -- yet as we all know now, that doesn't mean they were safer or less expensive.

Regardless of what happens to the markets in the coming days and weeks, you can expect general uncertainty about the economy to linger well into the future. In a tough market, you have to give yourself a competitive advantage by going beyond simply buying stocks based on intuition or whim. By learning even simple valuation techniques, you'll be a step ahead of others -- and may avoid making the panicked mistakes that trap less sophisticated investors.

For more on profiting in tough times:

• How to get the guts to buy.
• Three investing myths you should avoid.
• How to calm down when you're about to panic.