If Doc Brown, one of the main characters in 1985's Back to the Future, had actually invented a time machine shareholders of firearms manufacturer Smith & Wesson (SWBI 0.47%) would probably use it to go back in time and sell their shares in mid-June. As you can see below, since June 19, Smith & Wesson shares have completely misfired and are down 44%.

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Yet, in spite of the drop Wall Street seems to be enamored with Smith & Wesson stock. One of the sources of that infatuation could be due to the company's perceived "cheapness." But, what exactly is a "cheap" stock you ask? That's a question we'll answer today, as well as look into the catalysts that make Wall Street so confident that Smith & Wesson will head higher. Finally, we'll wrap up by looking at where Smith & Wesson's stock could be heading next.

How exactly is Smith & Wesson a cheap stock?
When it comes to investing there are more than a handful of ways of valuing a stock, but none are more of a tried and true method according to Wall Street firms than the price/earnings-to-growth ratio, or PEG ratio. A PEG ratio takes a company's price-to-earnings ratio, which is a measure of profitability over the trailing four quarters, and divides it into the company's forecasted growth rate over a specific period of time (most often a five-year period). This way Wall Street analysts and investors can determine whether or not a company is cheap based on its future growth prospects rather than having to look solely in the rearview mirror at its past earnings performance.

As an example, imagine a company had a P/E ratio of 20 and a forecasted growth rate over the next five years of 15%. In this instance our fictitious company's PEG ratio would be 1.33 (20 divided by 15). In general, any stock with a PEG ratio of one or lower is considered to be a cheap stock.

In the case of Smith & Wesson the company's five-year projected growth rate of 14% (based on Wall Street's estimates) places its five-year estimated PEG ratio at 0.74, well into the range of what would be considered a cheap stock.

Why Wall Street loves Smith & Wesson
However, firearms maker Smith & Wesson is more than just cheap by Wall Street's standards; it's also quite loved. Out of the nine Wall Street analysts currently covering the company, three of them rate it the equivalent of a strong buy, four the equivalent of buy, one a hold, and one an underperform. In fact, of the eight analysts willing to place a price target on Smith & Wesson the mean price target of $16.06 is a clean 68% higher than where Smith & Wesson closed on Friday.

But, what exactly is causing Wall Street to fall head over heels in love with Smith & Wesson's stock? I would contend that it boils down to two factors.

Source: Flickr user Sari Dennise.

First, Wall Street and investors are optimistic that the fear of potential gun regulation will continue to drive sales of both handguns and rifles. We've witnessed an unfortunate number of gun crimes in recent years and the potential for regulators to kick out significantly tougher gun legislation is still on the table. As long as this fear exists the idea is that firearm demand should remain higher than it historically has been.

The other factor is simply Smith & Wesson's valuation. Even though Smith & Wesson's sales and profits declined in its most recent quarter, the company is currently valued at a mere seven times trailing earnings and approximately eight times next year's profit projections. With the trailing P/E of the S&P 500 approaching 20, a company like Smith & Wesson offers compelling value that Wall Street has a hard time turning down.

Smith & Wesson appears cheap, but can the stock head higher?
In spite of being both cheap and loved by Wall Street's standards, there's no guarantee that Smith & Wesson shares will head higher. In fact, one needs only to look at its performance over the past few months as confirmation of this point. The reality is that Smith & Wesson is also facing headwinds that could drag down its share price.

Source: Flickr user Andrew Magill.

Perhaps the biggest drag on Smith & Wesson's stock is the fact that the fear trade has substantially wound down. In order for tougher gun legislation to be passed Congress would have to work together, and this Congress has shown an uncanny ability to do the opposite of that. In other words, with the chance of any meaningful gun legislation likely off the table for a few more months, or perhaps even years, the desire for consumers to buy firearms has declined. As Smith & Wesson noted in its second-quarter results, which were released in late August, net sales plunged 23% to $131.9 million. As the company further expounded, weakness in long gun sales (e.g., rifles) accounted for 87% of its sales decline.

The other major concern, which is really an extrapolation of the fear trade discussed above, is that falling consumer demand could cause inventory levels to skyrocket. Based on the rules of supply and demand, higher inventory levels could lead to discounting and lower margins for Smith & Wesson, which would render its low P/E not nearly as attractive.

As for me, personally, I'm optimistic on the firearm industry over the very long term, but feel that investors would be better served by looking at rival Sturm, Ruger (RGR) instead. Sturm, Ruger is expected to face many of the same headwinds that Smith & Wesson is currently facing (i.e., rising inventory levels and a decrease in consumer demand as the fear trade winds down). However, Sturm, Ruger can offer three things that Smith & Wesson cannot.

First, Sturm, Ruger is sporting a juicier profit margin over the trailing 12-month period of 15.1% compared to Smith & Wesson's 13.2%. This may not seem like a lot, but it can mean a big difference over the long term, and demonstrates that Sturm, Ruger either has some combination of better pricing and/or tighter cost controls.

Secondly, Sturm, Ruger is debt free and sporting $47.4 million in cash. Smith & Wesson, on the other hand, has $175 million in debt and a net debt position of $81.5 million. This modestly better cash position gives Sturm, Ruger more flexibility when it comes to expanding its business and developing new products.

Lastly, Sturm, Ruger is going to pay you to own its shares. Whereas Smith & Wesson offers no dividend to its shareholders, Sturm, Ruger is on pace to pay out a nearly 4% dividend yield over the next year. As investors wait patiently for demand to begin to tick higher again, Sturm, Ruger would appear to be the smarter buy within the firearm sector.