The Right Way to Be Wrong

Chicken Little is making a fortune shorting the stock market right now. Since 2008 rolled in, the market has dropped some 5%. Add to that recession fears, further housing troubles, and a slowing jobs picture, and panicked investors believe the pain may not stop.

The beautiful part about panic, though, is that it creates tremendous bargains. Stocks can get so cheap, in fact, that you can be wrong in your value estimates and still profit. Take, for instance, Home Depot (NYSE: HD). The housing meltdown has absolutely destroyed this company's stock. It's as if the market expects the housing market to never recover.

Embrace the fear
At the same time, though, analysts' five-year-growth estimates for the company clock in north of 12%. Clearly somebody's wrong -- either the market is unreasonably scared or the analysts have once again botched their projections. (Incidentally, it wouldn't be the first time for either.)

Of course, there's a third option: Everybody's wrong -- both the market and the analysts. In truth, that's probably what will play out in the end. That kind of scenario is exactly where you as an individual investor can profit.

Cut back and win
One of the biggest determinants of a company's future value is its rate of growth. A faster-growing company earns a premium valuation, while a slower-growing firm will trade at lower multiples. Even a modest change in growth can have a big impact on the value you estimate for a company:

The swings can be dramatic. That's a pretty big change caused by a few percentage points of lower growth. 

Use it to your advantage
By dialing down your expectations just a bit, you'll come up with a lower price you'd be willing to pay to own the stock. If the market still offers you a discount below even that lowered estimate, then it just might be time to buy. After all, an even lower price gives you even more breathing room to be wrong and still make money. 

That breathing room can come in handy. The wild swings in value calculated above came from just reducing expected earnings growth by a fourth. If there's a recession, earnings will likely decrease even more. If even your lowered estimates turn out to be too high for reality, you're going to want all the breathing room you can get. Check out the breathing room (or lack thereof) priced into those same companies:

How you profit
At these prices, Home Depot is already priced for terrible things to come. If those nasty things do happen, its already-discounted price should help protect your investment. Of course, you could have been wrong by assuming Home Depot would grow slower than the analysts' estimates. In that case, it simply has all that much more room to grow to reach its true value.

Lower downside risk. Better upside potential. That's the benefit of finding companies that trade well below lowered expectations. And it's how we look for investments at Motley Fool Inside Value. If you're ready to turn your incorrect valuations into an investing advantage, then join us free for 30 days.

At the time of publication, Fool contributor and Inside Value team member Chuck Saletta owned shares of General Electric. Home Depot is an Inside Value selection. The Fool has a disclosure policy.