The Worst Way to Invest in Today's Market

With the market still down about 25% 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 MasterCard (NYSE:MA), for which 12 separate analyst estimates for long-term earnings growth range from 7% all the way up to 25%. Price targets reflect these discrepancies and range from $140 to $237 a share (the stock currently trades around $174), predicting anything from a possible loss of 20% to a gain of 36%.

There's obvious disagreement in the analyst community as to how fast MasterCard 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, these back-of-the-envelope calculations reveal some intriguing research opportunities. Based on these rough valuations, Altria and Kraft appear undervalued, even if they perform only half as well as the Street predicts. Google, Intel, and Gilead, on the other hand, look more fairly valued today. Research In Motion will need to continue to fire on all cylinders to justify its current valuation, which makes it the riskiest of this group at the moment.

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 does not own shares of any company mentioned. Google is a Motley Fool Rule Breakers recommendation. Intel is an Inside Value pick. The Fool's disclosure policy is always a deal.