I learned the diversification lesson the hard way. Back in the winter of 2000, I held a few funds and a handful of stocks in my portfolio. The lion's share of the portfolio was in just one stock. Stupid, I know, but the one stock kept climbing, and I wanted to see how high it would go before selling some of those shares.

The one stock was Procter & Gamble, and it reached a high of $118 per share in January 2000. In February it dipped into the $90s on news of a possible pharmaceutical acquisition, and I did nothing. And then one day in March, I switched on my computer and learned that Procter & Gamble shares had fallen by 30%. The investment gods had taken me and my portfolio to the woodshed for an old-fashioned hiding, and I had no one to blame but myself.

So what was I to do? There were basically three possible options. I could sell all of my P&G shares and make a late entry into the high-tech bonanza that was still under way in the spring of 2000. Remember, the Nasdaq had increased by 107% in the year prior to P&G's meltdown, so getting in on the action seemed wise at the time. Or I could continue to hold the shares through the difficult period. Or I could buy more shares of the wounded elephant. I suspect this last option would have been recommended by Philip Durell and his Motley Fool Inside Value investment service.

The tiger awaits its prey
And Philip would have been right. Today, in May 2005, Procter & Gamble is up more than 150% since those grim days back in March 2000. In annual terms, that's a 20.3% return per year over the past five years for one of America's finest companies.

In retrospect, it all makes perfect sense. Think for a moment about how we determine the value of a firm. Essentially, a firm is valued by adding up the present value of all future cash flows, a very simple principle. Is it really possible that analysts woke up one morning and discovered that the present value of all of P&G's future cash flows should be reduced by 30%? Of course not. The market punished P&G because it didn't trust its CEO, Durk Jager, plain and simple. P&G was obviously overvalued at $118 a share -- and just as obviously undervalued at $55. The latter valuation is precisely the type of opportunity that Philip and his Inside Value team hunt for.

We make money the old-fashioned way. We earn it.
One of the keys to successful investing is knowledge. When P&G took its nosedive, I knew quite a bit about the company because I'd held the stock for many years. This helped me considerably in determining whether or not to buy (additional shares), hold, or sell the stock. For other stocks that may or may not become value opportunities in the future, it would be ideal if you had done your homework ahead of time. That way, you are ready when the situation arises.

The community at Inside Value is particularly helpful in arming individuals with the tools needed to outperform the market. Every month, Philip Durell recommends two value stocks, and also adds two or three companies to his watch list -- in fact, he recently added PetroKazakhstan (NYSE:PKZ) and Accenture (NYSE:ACN) to his watch list. On the discussion boards, there is an ongoing debate about which stocks represent good value opportunities. And on the Inside Value website, there is a very useful discounted cash flow (DCF) analysis calculator, which allows you to play a proactive role in the analytical process.

Armchair analyst
Note: You may want to skip this section if: (1) You find financial details too boring or difficult or (2) you're hungover.

Running a DCF analysis might seem like a fairly daunting task. You may even think you need to go to business school for two years before you can understand the mysteries of the process. Actually, our DCF calculator is quite easy to use, and most of the inputs can be obtained from a free online site such as Yahoo! Finance. Why trust the numbers of some smarmy Wall Street analyst when you can come up with more reliable valuations yourself?

The first required input is the discount rate, which is the return you'd require for holding a particular stock. For former Inside Value pick Coca-Cola, you might only require a return of 10%. For a riskier business like Taser, you might require a return of 15% to 16%. The next input is free cash flow. This term is defined in numerous ways, but to get started, we might calculate it by deducting capital expenditures from operating cash flows. If you prefer to skip that calculation, this figure can be obtained from Yahoo! Finance by clicking "key statistics" for any given stock. Next you need the annual growth rate, which you can obtain on Yahoo! Finance by finding analysts' estimates for the next five years. Then all you need is the current stock price and the number of shares outstanding. With just this information, you can begin the empowering process of valuing companies for yourself.

Let's look at some examples. I ran seven value candidates through Philip's calculator, and here's what I came up with:

Company Ticker Current Price Intrinsic Value*
MBNA** (NYSE:KRB) $20.77 $38.00
ConocoPhillips** (NYSE:COP) $102.58 $90.00
ExxonMobil** XOM $54.52 $66.00
Merck** (NYSE:MRK) $32.64 $36.00
IBM IBM $76.83 $88.00
Pfizer*** (NYSE:PFE) $28.55 $26.00
Eastman Kodak (NYSE:EK) $27.00 $28.00
* Calculated using the Inside Value discounted cash flow calculator.
** From the Inside Value watch list.
*** Pfizer was a March 2005 Inside Value recommendation.

Five of the companies are from the Inside Value watch list and the other two are famous blue chips. As you can see, the calculator provides us with an "intrinsic value" for each firm, which is simply what the stock should be worth based on the various inputs described above. As a result of my rough estimates of the inputs, the calculator reveals that four of the seven stocks are possible value candidates.

The calculator is best used as a preliminary indicator of a possible value opportunity. You would then need to do additional research to either confirm or reject your initial assumptions. For those who are unable or unwilling to devote too much time to this type of research, Philip provides thorough valuations of each of his picks and offers useful advice for those looking for assistance in this area.

If you can keep your head...
I ended up holding on to my P&G shares through the dark days and resisted the temptation to book a ticket on the high-tech Titanic. I sold off quite a few shares of P&G when it returned to a reasonable valuation in 2003, and then began the long overdue process of diversifying my portfolio.

The great value investor Warren Buffett once said: "Great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be misappraised."

Do you think AIG, for example, represents such an opportunity? Is now the time to scoop up cheap shares of this wounded elephant? Each day brings new and troubling information about the insurance giant. But regulators have also signaled that they are prepared to negotiate a deal. And the company continues to generate impressive free cash flows. Do you buy now, before things settle down and the stock rises in price again?

There are no easy answers here. I've spoken to Philip and I know he is following this stock very closely, in addition to the numerous other value candidates he keeps track of. If you think that the Inside Value investment service would help you to make the tough decisions, why not sign up for a 30-day free trial? You are under no obligation. You have my word. If you decide to sign up, give the DCF calculator a whirl. You might find that you prefer your own analysis to that of expensive Wall Street mercenaries.

This article was originally published as "Winning Ugly With Value" on April 20, 2005. It has been updated.

John Reeves owns shares in Procter & Gamble and Eastman Kodak. Taser is a Motley Fool Rule Breakers recommendation. Merck is a Motley Fool Income Investor recommendation. The Motley Fool has adisclosure policy.