7 Stocks That Give You Real Value

If you like to buy stocks at bargain prices, you've had no shortage of prospects to look at lately. But now that the rally has pushed share prices back up to somewhat pricier levels, you can't afford to get stuck with stocks that turn out to be value traps.

A tricky time
Value investors face a couple of challenges when they try to analyze stocks. First, the recession has turned many formerly profitable companies into money-losing ventures, at least temporarily. Even among those companies that have successfully avoided losing money so far, many have still seen their earnings drop significantly. In turn, that means that when you look at commonly followed measures like the P/E ratio, the "E" number is exceedingly low, which pushes the ratio value to misleadingly high levels.

In addition, even when the economy isn't in recession, earnings-based valuation methods still have their problems. Because earnings figures are determined by accounting rules, they can mean different things depending on the accounting conventions that a particular business chooses to use. Some industries will often use accounting methods that differ greatly from other industries, making it difficult if not impossible to compare one company's P/E ratio with a company in another industry.

Keeping it real
In an effort to make up for the shortcomings of the P/E ratio, many investors prefer to look at a company's actual cash flow as well as its earnings. In particular, free cash flow -- the amount of operating cash a company brings in minus the amount it spends on capital expenditures -- can give you an excellent indicator of whether a business generates actual cash that matches up with the earnings it reports. As important as earnings are for a company's success, having cold hard cash can open doors to opportunities, especially at times when capital markets are constrained and access to capital via debt financing isn't always reliable.

So out of curiosity, I looked for stocks that were still trading at attractive multiples not just to their earnings but also to their free cash flow over the past 12 months. Below are some of the stocks that came up:

Source: Capital IQ, a division of Standard and Poor's. Ratios based on trailing 12 month figures for earnings and free cash flow.

Just the beginning
Now before you run out and buy those stocks, realize that even though looking at valuations based on both earnings and free cash flow can help weed out some value traps, it won't catch them all.

In particular, when you look at trailing figures like the chart above does, you implicitly assume that the future will be at least as bright as the past. Because the economy has been in recession throughout the past 12 months, it's fairly reasonable to assume that if the economy recovers in the near future, most companies will enjoy a rebound both in earnings and free cash flow. Yet for at least some of the stocks in the table above, there are legitimate fears that the future may not look much better than the present.

For instance, as a seller of health-care plans, Wellpoint faces a great deal of uncertainty concerning the federal government's health-care reform bill. Although the current plan seems to make many allowances for private insurers -- which would seem to be good news for Wellpoint and its industry peers -- details in any final plan could threaten profits.

Similarly, future cuts in defense spending could endanger profitability at L-3. The recession has put refiners like Tesoro at the mercy of bank creditors who might force asset sales that could damage their core business. You'd want to have a firm grip on exactly how bad things could get for these companies before you conclude that they're good bargains.

The power of information
Even though you need to be cautious in looking at cheaply priced stocks, you can find legitimate values out there. As long as you look under the surface to figure out why stocks are bargain-priced, you should be prepared to deal with whatever the future may bring.