At Motley Fool Inside Value, we look to buy companies for less than they're worth, just like buying three tens for a twenty. There are generally two reasons that a company falls below intrinsic value. First, it is hit hard by negative news that causes a panic, as Doral Financial (NYSE:DRL) and AIG (NYSE:AIG) have experienced for the past few weeks. In the second case, there might not be a panic at all, but rather simply undue pessimism about the company or industry. Consequently, the price of the stock underestimates the growth potential or sustainability of the cash that the business is generating.

Panics are more exciting than pessimism -- people run around, wave their arms, and scream instead of simply being morose. But panics are often more risky, and consequently may not have a higher expected return than pessimistic stocks. Most of Warren Buffett's purchases in the past 20 years haven't been panic situations; rather, Buffett has waited for businesses about which the market was unreasonably pessimistic. The rewards can be huge, particularly in cases where earnings are growing and the price of the stock has yet to reflect that growth.

Consider homebuilders such as Lennar (NYSE:LEN) and Pulte Homes (NYSE:PHM). The market has been pessimistic about this sector for several years, but that hasn't stopped the stocks from returning 500%-plus since 2000. And that's without significant multiple expansion. Since I've previously discussed what to look for when trying to profit from panic, it seems appropriate to examine how investors can profit from pessimism.

Free cash flow
When you buy shares of a company, you're buying a share of its assets. But, more importantly, you're also buying a share of the company's future earnings. And I want my share of those cash flows to be as large as possible. Consequently, I'm looking for profitable businesses at reasonable valuations. Businesses that pump out cash are not only able to pay that money out to shareholders, but they also have more flexibility in a crisis and the potential to reinvest that cash to further increase earnings.

Generally, I like companies with enterprise value-to-free cash flow ratios of less than 15. I get extremely interested when it's less than 10.

Competitive advantages
When I examine a company to determine if it is undervalued, competitive advantages is often what distinguishes a company experiencing unjustified pessimism from one experiencing completely justified negativity. Competitive advantages allow a business to sustain and grow its earnings even in the face of competition. For instance, I use a particular bank for the sole reason that it has more bank machines in my area than any other bank. That network, which would be difficult and expensive to duplicate, provides a competitive advantage for my bank. And now, because I have an existing relationship with that bank, it has an advantage competing for my credit card and mortgage business.

To investors, competitive advantages are critical. It's not sufficient for a company to have strong earnings. Those earnings also have to be sustainable, and competitive advantages help ensure that they are. If you are confident that a company will still be profitable 10 years from now, then it is worth more than a firm whose future profits are less certain. That's why consumer product companies with dominant brands, such as Colgate-Palmolive (NYSE:CL), an Inside Value recommendation, are so desirable.

Great management
Leadership can make a huge difference in the value that accrues to shareholders over the long term. Consequently, I'm looking for companies where management receives reasonable compensation for their duties and makes decisions that benefit shareholders. For instance, I like to see share buybacks at less than intrinsic value and dividends paid to shareholders.

I'm predisposed against acquisitions unless they're in areas where the company will have strong competitive advantages or the company being acquired is significantly undervalued. For management, acquisitions are great -- increased revenue and responsibilities imply higher executive compensation. But from a shareholder's perspective, acquisitions are frequently dilutive to earnings, add complexity, and reduce focus on core markets. Consequently, when you consider the risks, the expected return for shareholders will often be lower than a simpler strategy of organic growth with share repurchases.

Return on equity
One sign of solid competitive advantages and great management is a high return on equity (ROE). ROE is the net income divided by shareholder equity. It shows how effectively the company is deploying its resources to generate cash. It's generally a good sign if the company has a higher ROE than its competitors.

If a company has a high ROE and it is able to deploy new cash at the same sort of ROE, it can be quite beneficial to shareholders because it can result in earnings compounding at a high rate. For instance, if a company retains $1 in earnings and is able to deploy those earnings at a 20% ROE, then the next year that company should earn an additional $0.20. It's unusual that companies are actually able to deploy new assets at such high rates of return, but any above-average rate can result in extraordinary long-term earnings growth. That's one reason why buying and holding companies with high ROEs can be extremely profitable

Bringing it all together
Many of these factors came together in the case of Polaris Industries (NYSE:PII), a manufacturer of all-terrain vehicles (ATVs), snowmobiles, and motorcycles. Polaris is in a cyclical market, and in the spring of 2001, there were fears about how the company would react to the recession. There was no panic, but people were pessimistic. Its price-to-free cash flow was 20, but this was deceptively high, largely as a result of inventory growth from poor snowfall and unusually high capital expenditures. A normalized price-to-free cash flow ratio would have been below 15, just above its P/E, which was about 11.

Determining Polaris' competitive position was challenging. My experience with ATVs was limited to the newsworthy antics of drunken rock stars. So, taking a page from the Gardners' playbook, I went to my brother for advice. As a redneck forester living in northern Canada, my brother regularly uses ATVs and snowmobiles for both work and recreation. He assured me that Polaris was a good company with high-quality products. In fact, as far as he and his friends were concerned, it was the top brand. The competitive position seemed solid, and the numbers (like its margins relative to competitors) supported that hypothesis.

In addition, the management was shareholder-friendly. They had been quietly buying back shares and raising the dividend for years. Polaris hadn't frittered away money on acquisitions, but instead was attacking related markets, like utility vehicles.

Polaris' ROE was extremely high, at about 40%. Plus, it had the potential to deploy its retained earnings for growth, as it had just started to take on Harley-Davidson (NYSE:HDI) in the cruiser segment of the motorcycle market. Most signs pointed toward a company with low valuation but good management, sustainable competitive advantages, and decent growth possibilities. I purchased the stock below $20, adjusted for splits.

Four years later, the company has lived up to its potential. Shares outstanding have declined by 10%, as Polaris continues its methodical share repurchases. Earnings per share have grown by 75%. The share price has done even better, as its multiple has expanded. Shares have been recently trading at more than $70, perhaps a bit ahead of fundamentals, but resulting in a pleasant 250% return. It's been a relatively comfortable ride during both the bear and bull markets.

The great thing about these undervalued stocks with strong cash flow and sustainable competitive advantages is that they have less risk than high-multiple growth stocks, but can still have spectacular returns. Those are the types of stock that Philip Durell targets each month in Inside Value. To find out what he sees as the truly great value plays right now, click here for a free 30-day trial.

Richard Gibbons, a member of the Inside Value team, thinks that grapefruits are simply a buggy beta version of the pomelo. He still owns Polaris, though he's sold some covered calls on part of his position. He owns none of the other stocks discussed in this article. The Motley Fool is investors writing for investors.