Value investors try to buy great stocks at cheap prices. Unfortunately, when a bear market pushes the price down on nearly every stock, the common ways of combing through stocks' valuations to find attractive candidates often turn up companies that aren't really great values right now.
4 ways to find cheap stocks
In trying to assess whether a stock is cheap, you have many different tools at your disposal. The most commonly used measure, the price-to-earnings ratio, can give you a useful snapshot of a company. But it -- along with a related measure, the PEG ratio -- has flaws, including the fact that earnings calculations are subject to accounting methods that don't always reflect economic reality, and that earnings can have temporary bumps and dips that don't necessarily play into a stock's future potential.
So, rather than relying on P/E, looking at other ratios can help build a more complete picture. To avoid the manipulability of earnings, looking at price-to-free cash flow ratios forces you to focus on the actual cash that a company brings in quarter after quarter. While a low P/E may just mean that a stock has artificial earnings, a good P/FCF ratio requires a steady stream of actual money coming into a business.
Price-to-sales ratios serve as a useful metric, especially for new industries where companies aren't yet earning profits, or when bad economic times produce losses that make the P/E meaningless.
Meanwhile, the price-to-book ratio examines the company's financial value as reflected on its balance sheet and compares it to its current market price. Although differences between a company's book value and the actual values of the assets on its books can make this metric misleading, it can still uncover some bargains when book values reflect assets' true values.
When ratios go awry
So, one method that you'd expect to use to find some promising value stocks would be to look for stocks that passed all of these tests. Looking for relatively low values on all those measures, I found the following stocks:
|
Stock |
P/E |
P/FCF |
Price-to-Sales |
Price-to-Book |
|---|---|---|---|---|
|
Bank of America |
13.2 |
1.3 |
1.26 |
0.44 |
|
Allianz |
10.8 |
1.6 |
0.35 |
0.96 |
|
NRG Energy |
4.7 |
10.9 |
0.81 |
0.83 |
|
Coventry Health Care |
8.8 |
3.7 |
0.22 |
0.78 |
|
Cabela's |
12.3 |
4.5 |
0.35 |
0.95 |
|
OM Group |
11.1 |
3.5 |
0.56 |
0.71 |
Source: Yahoo! Finance, Reuters.
As you can see, looking for low valuation metrics like these gives you a pretty diverse group, not all of which might seem like values to you. Certainly on the financial front, Bank of America has looked cheap for some time, but investors have had plenty of good reasons to shun the stock. Health insurance stocks like Coventry have felt pressure from the potential impact of health-care reform, which could cut profits and make current stock prices look much less like bargains.
But some of these companies look more promising. Despite problems in retail generally, Cabela's managed to post strong same-store sales increases of 8% in the first quarter. Energy stocks like NRG have been on the rebound lately, as oil has jumped past $60 a barrel and retail sales figures have started to show signs of a possible recovery. Similarly, specialty chemical-maker OM Group has essentially doubled in less than three months.
Look further
It certainly makes sense to use ratios like the ones above to find prospective value stocks for further research. But don't make the mistake of thinking that you can rely solely on attractive-looking measures to justify which stocks you buy. With many reasons why these figures can look cheap, you really need to dig deeper to understand fully whether any given stock is a great value or a value trap.
For more on smart value investing, read about:
- These doomed stocks aren't good values.
- Great companies for a recession.
- This is where you'll find great returns.
