How to Find Dirt-Cheap Value Stocks

The market has been all over the place lately -- down 300 points here, up 300 points there -- and all of that volatility is leaving tremendous value opportunities in its wake.

Consider the cases of BP (NYSE:BP) and Encana (NYSE:ECA), two solid but beaten-up oil and gas companies trading with single-digit price-to-earnings ratios, both 50% or more off their 52-week highs. If you need a new energy stock for your portfolio, you could do worse than starting your research here.

It's opportunities like this that value investors drool over. After all, the chance to buy dirt-cheap dream stocks only comes around so often.

But knowing how to spot the right value stocks in a down market is often more difficult than it sounds -- because there's a reason the market doesn't like some stocks right now. It's your job to figure out why, and whether the dislike is reasonable.

And one of the best ways I've found to identify promising deep value stocks is PYAD.

What's PYAD?
Developed by former Fool Stephen Bland at Fool U.K. in 1999, PYAD is a strategy that minimizes downside risk while maximizing upside potential. To this end, it looks for the P, the Y, the A, and the D:

• P/E ratio: less than two-thirds of the market's average.
• Yield: higher than the market average.
• Assets: price-to-book ratio below 1.
• Debt: manageable amount, preferably none.

A stock trading at a steep discount to the market and below the book value of its assets has already taken some tough punches -- and it could also be a sign that the worst is over.

But just because the market has stopped beating up on a stock doesn't mean it's ready to make nice and come to its senses. That could take time. And that's why having a healthy dividend yield is important. In essence, you're getting paid to wait for the rebound.

And finally, low or no debt reduces risk. After all, debt holders need to be paid before common stockholders, and high-interest expenses can make earnings more volatile. Stocks saddled with heavy debt loads are not usually worth waiting on.

All of these together suggest that a stock might be an excellent deep value play.

Right, but does PYAD work?
Out of curiosity, I used PYAD to look at U.S. stocks capitalized at greater than $200 million on Oct. 31, 2002 -- near the last bear market's bottom. Of the 10 stocks that met all four criteria, seven of them are in positive territory today, including Pinnacle West Capital (NYSE:PNW) and TECO Energy (NYSE:TE).

Those are pretty good returns for six years -- especially when they include the past few months.

So, which stocks would fit the PYAD criteria today? Here are a few of the contenders:

Source: Capital IQ, a division of Standard and Poor's. TTM = trailing 12 months. EBITDA = earnings before interest, taxes, depreciation, and amortization.

Of course, no screen, including PYAD, can tell you definitively whether you should buy a stock; they just provide starting points for further research. In this market, for instance, investors would be wise to take a very close look at a company's assets to gauge the risk of writedowns before making an investment.

And the next step, as it is with any potential value play, is doing a valuation to determine the company's intrinsic value. If a PYAD stock's true value is well above its current market price, you can sit back, relax, and let the juicy dividends flow in while you wait for the market to come around.

Time to value hunt?
The beauty of PYAD is its simple ability to identify stocks with limited downside. I think Warren Buffett, who famously quipped that rule No. 1 in investing is "Never lose money," would approve.

A strong company with limited downside selling at a discount to its intrinsic value is what advisors Philip Durell and Ron Gross look for at our Motley Fool Inside Value investing service -- and in this market, they're finding plenty. If you'd like to see what they're recommending now, consider a 30-day free trial. You'll also see all of their past recommendations and their best bets for new money now. Just click here to get started. There's no obligation to subscribe.

This article was first published Nov. 6, 2008. It has been updated.

Todd Wenning has the need … the need for speed. He does not own shares of any company mentioned. Discover Financial Services is a Motley Fool Inside Value selection. MVC is both a Motley Fool Hidden Gems recommendation and a Fool holding. No one puts the Fool's disclosure policy in the corner.