Sure, we all feel like geniuses now, right? We stuck it out -- "it" being the worst economic crisis since the Great Depression -- and have now enjoyed fat and happy double-digit gains ever since the market hit bottom in March.
There's surely more to come, right? Right?!
Survey says …
Who knows? We Fools pride ourselves not on making market calls, which is a great way to get slapped silly by the market's invisible hand, but rather on our fundamental focus. Is a company's market share likely to shrink or grow? Has its management team delivered the goods over the long haul while deftly navigating up markets and down? And in terms of valuation, does the firm's stock look like a blue-light special or a high-end luxury item?
In my experience, that last element -- valuation -- is often the toughest taco to crack. Some companies never look cheap, after all. Others that appear to be bargains may turn out to be value traps instead. Still, in general terms, one thing remains true: When a company sports moon-shot multiples, there's little opportunity to cushion the blow when the overall market hits the skids or when the company itself blows up.
The higher they fly, the harder they fall
For example, take Research In Motion and Google. The former has gained nearly 90% year to date, while the latter has increased by more than 40%. Yet sneaking a peek at this illustration of recent history should be instructive for folks who currently own either company's shares, as well as Fools who may be considering a purchase.
Could investors have foreseen the slide that chopped at least 50% off each company's value? Perhaps not, but if they'd tuned into each firm's valuation, savvy investors might have dodged a bullet by taking gains, waiting for valuation gravity to work its magic.
Shortly before its slide began, Research In Motion traded at a level that priced in more than 60 times the previous year's earnings. Google, meanwhile, sported a P/E in the 50s back when we were celebrating New Year's 2008. And while both companies have since recovered, RIMM now trades with a P/E in the 20s, while Google sports a multiple of just south of 40.
Bottom line: A little valuation discipline can go a long way. When an all-but-inevitable market pullback arrives, highfliers can be sitting ducks -- and future bargains, at least in relative terms.
Good company, lousy investment
Following robust run-ups over the last six months, Wells Fargo
Make no mistake. Like Google and RIMM, these are fine businesses; their stocks just aren't finely priced. Indeed, with their swollen multiples, the downside risk of dreaded "multiple compression" is just too great, particularly when long-haul overachievers like Procter & Gamble, Pfizer
If those discounted cash-cow gushers aren't the droids you're looking for -- and if you're really focused on high-flying heavyweights with ample room to run -- consider Berkshire Hathaway
The Foolish bottom line
There's more to uncovering values than just parsing price multiples. Separating truly cheap stocks from merely cheap-looking ones is a full-time job.
If you'd like some assistance when it comes to avoiding value traps, be sure to check out the Fool's Inside Value service, where the emphasis is squarely on rock-solid companies trading for a song. Click here and you'll have 30 no-risk days to decide whether Inside Value is for you. There's no obligation to subscribe and your guest pass is absolutely free. Give it a go now.
This article was first published June 2, 2009. It has been updated.
Shannon Zimmerman runs point on the Fool's Ready-Made Millionaire and Duke Street services and doesn't own shares of any of the companies mentioned in this article. Google is a Motley Fool Rule Breakers recommendation. Berkshire is an Inside Value and Stock Advisor selection. The Fool owns shares of Berkshire Hathaway and has a strict disclosure policy.