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Value or Value Trap?

By Shannon Zimmerman - Updated Nov 11, 2016 at 4:41PM

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Here's one way to separate the keepers from the duds.

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 Friday's closing prices finds more than 6,800 companies trading at levels 50% or more below their 52-week highs, a group that includes Apple (NASDAQ:AAPL), Apache (NYSE:APA), UnitedHealth (NYSE:UNH), and Caterpillar (NYSE:CAT). Filter that lineup again, this time seeking companies trading at least 60% below their yearly highs, and you're still left with more than 5,700 names. Citigroup (NYSE:C) and Marathon Oil (NYSE:MRO) make that unkind cut, for example, as does eBay (NASDAQ:EBAY).

 So, 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 company's business risk -- thus uncovering a company's intrinsic value. If the current share price falls below that number, the company 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 the new year, 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. Apple, UnitedHealth, and eBay are Motley Fool Stock Advisor choices. UnitedHealth is also an Inside Value recommendation. The Motley Fool owns shares of UnitedHealth and has a strict disclosure policy.


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Stocks Mentioned

Apple Inc. Stock Quote
Apple Inc.
$169.24 (2.62%) $4.32
eBay Inc. Stock Quote
eBay Inc.
$48.50 (1.04%) $0.50
Citigroup Inc. Stock Quote
Citigroup Inc.
$53.19 (2.11%) $1.10
Caterpillar Inc. Stock Quote
Caterpillar Inc.
$190.72 (2.52%) $4.69
UnitedHealth Group Incorporated Stock Quote
UnitedHealth Group Incorporated
$537.72 (0.09%) $0.46
Marathon Oil Corporation Stock Quote
Marathon Oil Corporation
$22.34 (1.73%) $0.38
Apache Corporation Stock Quote
Apache Corporation
$33.22 (1.65%) $0.54

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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