When we're out shopping, most of us instinctively know when something is a good deal. If I see a vintage Hot Wheels car for only $5, I'll snap it up in a heartbeat. But stick a share of Wal-Mart on the shelf priced at $42.99, and most of us might think twice before dropping it in our shopping cart.
Finding a good stock bargain can be a little more difficult than valuing your favorite trinket. But three basic stock-selecting steps can help you snag great deals and earn better returns.
The sky is falling
Following the market's recent hiccups, plenty of stocks have retraced their gains. Yahoo! (NASDAQ:YHOO) has dropped 17% in the past three months, as the Internet giant takes it on the chin from online ad competitor Google (NASDAQ:GOOG). But Gilead Sciences (NASDAQ:GILD) is down more than 9% in the same time frame, more because of larger, macroeconomic events than any deterioration in its fundamentals. Heck, even shares of MasterCard (NYSE:MA) have sunk 10% over the last month, apparently because the company didn't beat analysts' estimates by a sufficiently wide margin in its latest earnings release.
With all these knives falling around the market, investors are smart to take advantage of depressed stock prices. But nabbing a good stock deal requires investors to understand the basics of how to value stocks. With an estimate of a company's value in hand, the next step -- defining your margin of safety -- is just as important. Passing on a stock because the price doesn't meet your margin of safety is akin to walking past that $7.99 facial cream, knowing that while it's not exactly full price, it's not a screaming buy, either.
On the road to cheap
Here are three quick tips to bring out your inner bargain-hunter:
1. Determine intrinsic value.
There are different ways to estimate a company's inherent value, but they're all inexact. Some investments such as REITs lend themselves to valuation based upon net asset value, while a discounted cash flow (DCF) valuation is common for stable, cash flow-positive companies. Plenty of resources here at The Motley Fool explain different types of valuation and offer examples of how to calculate the intrinsic value of a company.
2. Determine your margin of safety.
How far below its estimated fair value would you feel comfortable buying a given stock? Adding a margin of safety leaves room for error in your calculation of a stock's worth. Your margin of safety may vary, depending upon your tolerance for risk, the uncertainties in a particular stock, or market conditions in general. For instance, you may be comfortable demanding a smaller margin of safety (20%) on a more trusted, stable company such as Johnson & Jonhnson (NYSE:JNJ) or Chevron (NYSE:CVX), but insist upon a greater discount on a younger, more growth-oriented company such as Garmin (NASDAQ:GRMN).
3. Consider easing in.
With cheap trades offered by brokers today, it's more feasible for investors to purchase stocks in portions. Consider buying a smaller block of stock if it's cheap, reserving a portion of capital for further buys if it gets even cheaper.
The Foolish bottom line
Valuing a stock is an inexact science. After all, snapping up shares of a fundamentally deteriorating company could land you a great price on shoddy merchandise. And there's no assurance that even the best investors' estimations are on target. But placing even an educated guess at a company's value gives investors a better chance of being right on average -- and seeing market-beating returns -- in the long run.
Philip Durell and his team of bargain-hunters at the Motley Fool Inside Value investing service scour the market every day for stocks on the cheap. So far, his average stock pick is beating the market by nearly three percentage points. To see which stocks the team recommends today, try the service free for 30 days ... and then pat yourself on the back for getting another great deal.
Fool contributor Dave Mock hates shopping, but still can't resist a good sale. He owns shares of Garmin. The longtime Fool is also the author of The Qualcomm Equation. Yahoo! and Garmin are Motley Fool Stock Advisor recommendations. Johnson & Johnson is an Income Investor recommendation. The Fool's disclosure policy is a bargain at twice the price.
