The Worst Way to Invest in Today's Market

With the market still down 30% over the past year, there should be plenty of cheap stocks out there today. Right?

As with any market, the short answer is, "It depends." More specifically, it depends on what type of growth you're expecting from the companies you research.

Do you see a butterfly? Or a moth?
Growth estimates for corporate earnings vary widely among Wall Street analysts, and thus produce very different valuations for stocks. Consider the case of eBay (NASDAQ:EBAY), where eight separate analyst estimates for long-term earnings growth range from 10% all the way up to 45%. Price targets reflect these discrepancies, and range from $12 to $23 a share (the stock currently trades around $17), predicting anything from a possible loss of 29% to a gain of 35%.

There's obvious disagreement among the analyst community as to how fast eBay can grow in the coming years, so whose estimates should you trust?

The best policy is not to fully trust any of them. Instead, use their consensus as a starting point for your own estimates. See, Wall Street estimates have proved extremely optimistic on average. And as a study by Patrick Cusatis and J. Randall Woolridge of Pennsylvania State University showed, their five-year growth estimates are off by nearly 40% on average.

In other words, relying on Wall Street estimates to value companies is a quick way to destroy your portfolio. And these days, that's something you simply can't afford to let happen again.

So don't let it
Based on the findings of the Cusatis and Woolridge study, a simple rule of thumb when making conservative growth estimates is to take the median analyst estimate and cut it in half. If the stock's still a value at that point, it's worth further research.

Looking at a number of the market's more popular large caps along with current Wall Street estimates and the assistance of the Motley Fool Inside Value discounted cash flow calculator, we can begin to see where true market values may lie. In each valuation, I discounted free cash flow estimates by 10%, and assigned 3% terminal growth.

Source: Capital IQ, as of June 16, 2009.

Please note that none of these should be taken as stock recommendations or official valuations. Still, they reveal some intriguing research opportunities. Based on these rough valuations, Home Depot, Johnson & Johnson, and Microsoft appear quite undervalued, even if they perform only half as well as the Street predicts. ExxonMobil could be less of a growth opportunity, but is also worthy of further research, especially if you think oil prices could go higher. PepsiCo and Caterpillar, on the other hand, look more fairly valued today. This would make sense, since PepsiCo did do relatively well during the past year, down some 20% versus the S&P's approximately 30% loss, and Caterpillar has rallied in recent months on the back of higher commodity prices and other "green shoots."

Selectivity is key
There are still some tremendous values out there, but relying on Wall Street earnings estimates to determine those values is the worst way to invest in today's market. If you want to begin to rebuild your portfolio from the recent market mess, now's the time to be more conservative with your outlook. Cautious estimates will not only help you find today's true market values, but also help protect you from being too wrong if something unexpected happens at the company or with the economy.

If you'd like some help finding more stocks trading at deep discounts to their fair value, you should consider a free 30-day trial of our Inside Value service. The Inside Value team scours the market for the best deals each month, and shows you how to better analyze the stocks in your portfolio.

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This article was first published on May 8, 2009. It has been updated.

Fool analyst Todd Wenning believes that slow and steady wins the race, but fast and flashy wins sponsors. He owns shares of Home Depot. Home Depot, Microsoft, and eBay are Motley Fool Inside Value selections. Johnson & Johnson and PepsiCo are Motley Fool Income Investor picks. The Fool owns shares of Starbucks. The Fool's disclosure policy is always a deal.