The mission of Motley Fool Inside Value is simple: we want to find companies trading at prices less than their fair value. In some cases, companies are below fair value simply because the market has failed to appreciate the sustainability of a company's competitive advantage. At other times, companies fall below their fair value during a crisis, when panicked investors flee. The latter case has the potential for quick returns, but also comes with greater risk. When looking at companies in crisis, such as UTStarcom (NASDAQ:UTSI) recently, it can be challenging to distinguish between a company just suffering a flesh wound and one on its deathbed.

For UTStarcom, the issue is whether it can cut its expenses enough to overcome falling revenues from China and survive until other international operations and third-generation wireless networks provide significant revenue. If so, investors may do quite well.

Consider Alderwoods Group (NASDAQ:AWGI), a funeral home operator that arose from the bankruptcy reorganization of the Loewen Group. The Loewen Group, like its competitors, had grown in the late 1990s by taking on debt to purchase smaller operators at inflated prices, but it couldn't handle the debt load. Stock prices were still suffering in early 2003, but the fundamentals of the industry had actually turned around. For months, investors could have bought shares below $4. Those shares are now trading for about $12 -- a nice 200% return. Much larger multibaggers over the course of years are easily within reach. The difficulty, though, is determining who will survive and prosper. With that goal in mind, here are some of the issues I consider when trying to profit from panic.

In a crisis, cash gives a company the time and flexibility to survive a rough patch and reorganize its business. It's critical to get a good feeling for the degree to which cash on the balance sheet and future cash inflows are able to cover future cash outflows. Of course, the event causing the crisis often reduces operating cash flows, so using historical cash flow numbers can be deceptive. Instead, start with historical numbers and come up with a pessimistic approximation of the extent to which the negative event will impact cash flows, and how much cash outflows can be reduced over the short term through, say, delaying capital expenditures. If the company is close to the edge, there's a good chance it will topple over. In that case, avoid it.

Even if cash flow looks good, another liquidity issue to consider is debt. Even if it seems clear to shareholders that the company has enough cash flow to survive, banks and other lenders can be skittish. So it's a good idea to examine absolute levels of debt and future debt maturities. If the company is highly leveraged, or a substantial portion of its debt is coming due in the next few years, then the company may be unable to roll that debt over to future maturities. Often, it's not the slow draining of cash resources that leads to bankruptcy, but rather a large debt maturity that the company is unable to roll over or repay.

For instance, two of the most discussed beaten-down stocks right now are General Motors (NYSE:GM) and its main parts supplier, Delphi (NYSE:DPH). GM still has significant market share, strong brands, and hundreds of billions of dollars in revenue, so it's natural to wonder whether GM and Delphi have been battered too much. But the problem is GM's future liabilities. Not only does GM have over $30 billion of debt on its balance sheet, it has $268 billion of debt associated with General Motor Acceptance Corp., its financing subsidiary. What's more, it has about $185 billion in pension and health-care benefit obligations that could torpedo the company.

GM's problems aren't going away any time soon (nor are Ford's (NYSE:F), for that matter), and they're problems foreign competitors like Honda (NYSE:HMC) don't have. GM shares peaked at over $90 in 2000, a price about triple where the stock is now. GM's very unlikely to be a 10-bagger. So, considering the risks and weight of debt, I think GM still looks like a poor bet.

Asset strength
When it comes to turnarounds, the balance sheet can count more than the income statement. I've already talked about debt. Another factor to consider is the strength of the assets, because all assets are not equal. Cash is the best asset, since it gives maximum flexibility. Other good assets include securities and non-depreciating physical assets that can potentially be sold, such as real estate, which can be tricky to value since accounting rules tend to make it significantly undervalued on the balance sheet.

There are also bad assets that generally cannot easily be sold or generate cash. Such assets include goodwill and tax assets. Goodwill is useless because it's intangible, while tax assets can only be converted into cash when the company has operating profits -- something scarce during a crisis. So when considering a company's survival prospects, it's best to heavily discount the value of these assets.

The competitive position
Preferably, we buy a beaten-down company not just for its assets but also for its future operating performance. Ideally, the company is suffering from temporary bad news, but its long-term competitive position is intact. Maybe the company will show poor results for a year or two but is likely to prosper after that time. Perhaps the company has suffered a permanent setback but is still strong enough to be a viable business.

PetroKazakhstan (NYSE:PKZ), a Canadian oil company with operations in Kazakhstan, has been arguing with regulators, fighting with its joint venture partner, Russia's Lukoil, and its CEO retired. The shares have been creamed in the past few months, falling from $45 to $27. Its competitive position has definitely weakened: contracts and deals in the republics of the former U.S.S.R. seem less binding than those in the United States. So, tangling with the local boys does weaken PetroKazakhstan's competitive position. At the same time, the stock looks really cheap, with a P/E ratio of about 3.5. The question value investors are asking is whether the risk of PetroKazakhstan losing everything justifies such a low P/E.

Bringing it together
A good example of all these issues is National Health Investors, a REIT that primarily owns nursing homes. As you can see in this chart, National Heath was flying along quite happily when it hit the perfect storm. The Balanced Budget Act of 1997 cut Medicare revenues to its nursing home operators, the companies that lease National Health's buildings. Consequently, many operators went bankrupt. Plus, it was affected by overbuilding and labor shortages. Finally, lawsuits in Florida were destroying the business there.

Confronted with these challenges, National Health collapsed like Mr. Bean sparring with Evander Holyfield. I became interested, and bought shares at $15. This was a wee bit early, since it cratered below $5 when the company discontinued its dividend only six months later. But this wasn't a technology company. It had solid real estate assets in a time of falling interest rates. Cash flow was still positive. The entire industry was unlikely to vanish: Somehow, someone would take care of the elderly. So I bought more at $5, and it started to look like the industry was recovering.

But National Health owed money to the banks. And the banks panicked, demanding repayment. So National Health was forced to sell convertible preferred shares at a time when the stock was low, diluting existing shareholders. I bought more in the $6 range. Cash flow was still good, nursing home operators were coming out of bankruptcy, and the balance sheet, never really overleveraged to begin with, now looked quite clean. It was difficult to see how National Health could fail.

Now, four years later, the stock is trading around $25. That's lower than it would be if it hadn't been forced to issue the convertible, but it's still a decent return. For months, value investors bought in the $6 range, and those investors have seen a 400% return. What's more, since National Heath has a $1.80 dividend, investors at $6 are now seeing an annual dividend of 30% on their original investment. I sold out at $22.

The key points in this case were that cash flow was positive, leverage was reasonable, the assets were strong, and there were signs that the industry would turn around. Even then, the debt maturity hurt shareholders significantly, because nobody wanted to lend to companies in the sector. This is why, when analyzing these turnaround situations, it is critical to consider debt maturities.

Evaluating these factors can help you find and identify turnaround plays that lead to extraordinary profits. For instance, in 2002, both Philip Durell, Inside Value's chief analyst, and I independently recognized that Providian Financial had a decent chance of rebounding. I bought at about $4, while Philip bought for $2 and change. It's now around $17. If you want to learn about what Philip sees as the great value plays right now and read all of his recommendations, a free 30-day trial is available.

This article was originally published on March 11, 2005. It has been updated.

Richard Gibbons , a member of the Inside Value team, still owns shares of Providian, but, now that people have stopped panicking, he's sold some of his position. He owns none of the other stocks discussed in this article. The Motley Fool is investors writing for investors .