Beware of "Bargain" Stocks

The plunging stock market has created bargain opportunities for investors to exploit. But before you go picking cheap stocks willy-nilly, make sure you're not cutting corners on your research -- or you could get a nasty shock in the future.

Once you've followed a particular stock for a while, you get a sense of how it trades and performs in relation to the overall market. You learn how different industries work and how stocks in those industries get valued, and how their performance moves up and down with the economic cycle.

With unfamiliar stocks, though, you don't have that experience, so it's tempting to fall back on some simplistic valuation indicators. Yet that's exactly where you can get yourself into trouble if you're not careful.

Why simple valuations can be wrong
For instance, one of the most commonly used valuation indicators is the simple P/E ratio. For beginners, it's an easy ratio to follow: You can always find out a stock's price, and public companies disclose their earnings at least once every quarter. You don't necessarily need to understand balance sheets or income statements -- just plug in the numbers and you have your answer.

But one fundamental mistake that many investors make is forgetting to look forward. That's dangerous at any time, but it's particularly problematic in a slowing economy. What conclusions, for example, would you draw from seeing the following two different sets of P/E figures?

Source: Yahoo! Finance. As of Jan. 14 close.

The first column, which lists the companies' trailing P/E figures using earnings over the past 12 months, makes all of these stocks look cheap. But when you look into the future and recalculate P/E based on forward estimates, you get a much different picture. Companies like Freeport McMoRan and Eastman Kodak suddenly look a whole lot more expensive.

Other pitfalls
Failing to look forward with earnings is a basic mistake that beginning investors make with P/E ratios, but it's far from the only one. Here are some other things to watch out for:

• Do you trust earnings? Sometimes, you'll run into accounting methods that obscure the underlying financial condition of a company. If GAAP earnings don't give you a good understanding of a stock's valuation, then you may want to use other measures, such as non-GAAP earnings figures or free cash flow.
• Can you guess the future? In tough times like these, forward P/Es are often lower than trailing P/Es. More commonly, though, optimistic growth estimates make forward P/Es look much more reasonable, tempting value investors into buying shares they might otherwise think were overpriced. Basing too much of your opinion on earnings estimates for two, three, or even five years out can be risky, though -- especially given how speculative those estimates can be.
• Know your industry. Valuations differ from one industry to the next, reflecting differences in growth prospects and capital requirements. So while a certain P/E level may look attractive compared to the market as a whole, it may actually indicate that a stock is overpriced compared to peers trading at even lower earnings multiples.

So when you're doing research on promising new stocks you don't know well, remember not to rely on a single valuation indicator. Check out a stock thoroughly, and you'll avoid many of the mistakes that beginning investors often make.

For more on finding value in today's market, read about:

• Your best chance to reap profits in 2009.
• Priceless investment advice from Warren Buffett.
• Wall Street's biggest secret.