7 Dirt Cheap Stocks

Last week, Marc Mogull, a former director in the European property group at Goldman Sachs, dropped a bombshell: He had raised $2.6 billion to invest in European property. So far, so good -- but so what?

Mogull said he was not calling a market bottom, but he added, "Buying a quality building below the cost of replacement gives me a lot of comfort."

"Below replacement cost" in any other asset class would smell just as sweet
If buying a building below the cost of replacement provides an investor with protection against a permanent capital loss, why should it be any different for a stock investor? After all, shares represent an ownership interest in a company, which has a replacement value.

If you buy the shares at a price that amounts to paying less for the business that it would cost to build it from the ground up, it's a good bet that you're paying a dirt cheap price. Ultimately, the market will recognize the value, either through increased demand for the shares from stock investors or through an acquisition offer.

So how does one compare a company's market value to its replacement value?

Enter Tobin's q …
… otherwise known as the q ratio, named after Nobel prize-winning economist James Tobin.

Tobin's q = market value of the company / replacement value of the company's assets

The q ratio is much less widely known than the price-to-earnings or the price-to-book value, which is a shame because it's a powerful metric. One reason it's less popular are the challenges associated with calculating replacement value -- an economic concept, rather than an accounting concept like book value. Thankfully, there is a formula that approximates the q ratio that depends solely on basic financial and accounting data. (If you really want to know, it's (market cap + preferred equity + long term debt + current assets - current liabilities) / total assets.)

The following table contains seven stocks with an estimated q ratio below the long-term average for companies in the S&P 500 (furthermore, all seven, except for Boeing, are in the lowest decile in terms of their q ratio):

*Note that the long-term average for q is lower than 1 for a variety of technical reasons that I won't bore you with. Source: Capital IQ, a division of Standard & Poor's. Data as of Feb. 2, 2009.

A couple of remarks are in order: First, it's pretty clear that the P/BV multiple and q aren't identical. For Caterpillar and Boeing, for example, the difference is a factor greater than 7:1. These are situations in which using the P/BV alone might cause us to throw out those stocks as overvalued when the q ratio suggests that they are undervalued.

Second of all, the q ratio does not exempt investors from doing due diligence based on qualitative as well as quantitative factors. With a q ratio under 0.2, General Motors might appear undervalued; however, the risks linked to the company's financial position and the consequences of a government bailout characterize a speculation, not an investment.

Exchange operators on the radar
Lastly, I'm gratified to see two exchange operators (NYSE Euronext, CME Group) show up in the list of low-q stocks. Of the stocks in the table, this is the sector I know best, and I think it is undervalued. The stocks of NYSE Euronext and CME Group have suffered steeper losses than the KBW Bank Index over the past 12 months, even though these companies don't face anywhere near the same business risk as banks. Unearthing both stocks suggests that there is some merit to screening with the q ratio.

This exercise is a good blueprint of the way value investors (among which I count myself) go about looking for value:

1. Think about your downside first: In this case, the key notion is that stocks trading below their replacement value provide investors with significant of protection against permanent capital loss.

2. Screen for stocks that look cheap.

3. Start with the results of your screen, perform further due diligence, discard the stocks that turn out to be only statistically cheap, and focus on those that are genuinely undervalued.

Next steps

That is just one of a variety of approaches Philip Durell and his team at Motley Fool Inside Value use to find well-protected, undervalued companies. If you'd like to find out more about their approaches, and get the five best stocks they're recommending for purchase now, you can take advantage of a 30-day free trial today.

Fool contributor Alex Dumortier, CFA, has no beneficial interest in any of the companies mentioned in this article. NYSE Euronext is a Motley Fool Rule Breakers pick. The Motley Fool has a disclosure policy.