Don't Get Trapped by False Value Stocks

Value investors always seek stocks that are trading below their intrinsic value. So, when you see a company whose financials suggest that its shares are a huge bargain, should you hesitate to jump right in and buy?

Of course, the bear market has caused many stock valuation measures to plummet. But lately, a huge number of stocks are trading at extremely attractive levels -- levels that imply that buyers are getting something for nothing.

Is that a symptom of just how irrational the selloff has become? Or are these apparently attractive prices actually a value trap waiting to snare unsuspecting investors?

Looking at book value
A company's book value is one of the simplest measures of a company's worth. All you need to calculate book value is a balance sheet. By taking the total value of a company's assets and subtracting out debt and other liabilities, the remaining amount should represent the equity that shareholders own in the company.

There's no shortage of stocks trading at prices below their book value per share right now. Here's just a sampling:

Source: Yahoo! Finance.

Investors who trust book value as accurately representing the value of a company's assets and liabilities would be buying these stocks hand over fist, scooping up investments trading at pennies on the dollar in hopes of an eventual recovery.

What's wrong with this picture?
Obviously, there's a catch. Here, it's the assumption that book value isn't just a figment of an accountant's imagination. In some cases, that's pretty questionable, especially right now.

For instance, take a closer look at NYSE Euronext. Of its roughly $14 billion in assets as of the end of 2008, goodwill and other intangible assets composed over $9.8 billion. Given the rate at which many companies have been taking impairment charges to goodwill lately, it's highly probable that investors aren't giving full weight to that asset on the balance sheet.

If you take out goodwill and other intangibles and consider only the tangible assets on the books, you get a much different picture of the company. Tangible assets are actually worth less than outstanding liabilities, making it clear that at least on that basis, the company is far from the bargain it appeared to be when looking solely at book value.

Other industries have other issues. Industrial companies like Dow Chemical have substantial amounts of assets tied up in plants and equipment, where book value may not accurately reflect current values. And with financial stocks, we know all too well how dicey the values of some of their toxic assets have turned out.

Stay out of the trap
The book value trap is just another example of how simple valuation methods can lead you astray. But that doesn't mean that book value is useless. If you know how stated book value distorts the actual intrinsic value of a company's assets, then you can adjust for it and make smart conclusions about which stocks still look attractive. Moreover, you'll sometimes find that book value actually understates the true value of an asset -- especially one that has been held on the books for a long time.

Value investing remains a lucrative way to profit from the market's inefficiencies. But you can't simply look at a single measure of valuation and draw conclusions from it. Book value is a useful metric, but it's only one of many tools that experienced investors use to decide whether a stock will make a strong value stock. By incorporating book value analysis with other valuation methods, such as those based on earnings, revenue, and cash flow, you'll be more certain that the stocks you choose really are great values.

For more on smart value investing, read about:

• Why you should love higher taxes.
• Dreadful stocks you must avoid.
• Are stocks oversold or overbought?