As investors, we're interested in uncovering stocks that Mr. Market, for whatever reason, has mispriced. Hey, we're opportunists, right? There's some skill involved, too. After all, ferreting out value before the "smart" money does is the name of the game if you want to beat the market.
Dirt cheap buys
The trouble is that, these days, seemingly cheap stocks are plentiful. A quick screen based on Tuesday's closing prices finds more than 6700 companies trading at levels 50% or more below their 52-week highs, a group that includes GE (NYSE: GE), Merck (NYSE: MRK), Schlumberger (NYSE: SLB), and Nokia (NYSE: NOK). Filter that lineup again, this time seeking firms trading at least 60% below their yearly highs, and you're still left with more than 5,600 names. Google (Nasdaq: GOOG) and Siemens AG (NYSE: SI) make that unkind cut, for example, as does News Corporation (NYSE: NWS).
All of which begs the following question: Should you head to your favorite discount brokerage and start placing orders ASAP?
Cherry-picking rewards
OK, that question was a gimme. If you're reading this, you probably know very well that stocks frequently trade well off their highs for good reasons. Your job as a savvy investor is to separate the keepers from the duds -- and, from there, pick the very best bets.
That's easier said than done, of course. For my money (and yours), discounted cash flow (DCF) analysis is a great way to proceed. With DCF, your primary focus is on the real cash a company generates, not earnings, which are all too often stage-managed for the Gucci-loafer set on Wall Street. Your focus is certainly not on out-year earnings growth rates, which are notoriously difficult to predict with any degree of accuracy.
Instead, DCF fans will total a company's cash from operations, subtract capital expenditures, and make modest assumptions about earnings growth. They then apply a discount rate -- for example, the return they require, given the firm's business risk -- thus uncovering a company's intrinsic value. If the current share price falls below that number, the firm may be worth looking into. If not, DCFers will look elsewhere. Remember that even during periods of market froth, it's still possible to uncover values.
Despite being a huge fan of DCF, I realize there are other tools in the investing toolbox. Rich profitability metrics -- such as return on assets (ROA) and return on equity (ROE) -- are essential, too, as is a management team's ability to delivery market-shellacking returns for their shareholders over the long haul as well. Past performance is no guarantee of future results, of course, but as a yardstick for gauging executive-suite acumen, it comes in mighty handy.
In other words, the next time you're eyeballing a list of stocks trading near 52-week lows, be sure to investigate their seemingly discounted multiples relative to their forward-looking prospects and historical success.
So, now what?
We use all of these tools at Ready-Made Millionaire, the real-money investment service I head up. The Fool has plunked down a million bucks on our Ready-Made lineup, which includes a clutch of great companies trading at what I believe is a tremendous discount relative to their value. This set-and-forget portfolio is designed to beat the market over the next three to five years and beyond. All told, our approach at Ready-Made is probably best characterized as "growth at a reasonable price" or, as the cool kids like to call it, GARP.
We'll be opening the doors to new members in just a few short weeks, and between now and then, you can download -- for free -- our 11-Minute Millionaire special report, a Foolish write-up designed to help you make the most of up markets and down. Just click here to snag the report and learn more about Ready-Made Millionaire.
This article was originally published on Feb. 28, 2006. It has been updated.
Shannon Zimmerman is the lead analyst for the Fool's Ready-Made Millionaire newsletter service. He doesn't own any of the companies mentioned. Nokia is a Motley Fool Inside Value recommendation. Google is a Rule Breakers choice. The Fool has a strict disclosure policy.
