Walk Away From These Stocks

"Sorry we couldn't do business" is a phrase you'll hear from brokers at the Gold & Silver Pawn Shop in Las Vegas when a deal just doesn't make sense.

And no, I didn't find this out by trying to hock my grandfather's watch. This pawn shop is featured in a new History Channel show called Pawn Stars. As a history buff -- and an investor -- I've quickly become addicted to the show.

It's amazing what some people bring in either for sale or to pawn, like an 1849 Colt revolver and Salvador Dali proofs. Everyone has a great story to tell -- they're trying to get top dollar, after all. But for the pawnbrokers, a good story isn't enough. The price also has to be right.

See, if the pawnbroker gets all googly-eyed about a great story and overpays for it, he'll be unable to make a profit when he tries to sell the item in question. A string of mistakes like this will quickly put him out of business. That's why, if the price isn't right, a successful pawnbroker will simply walk away -- no regrets.

As investors, we could take a page from the pawnbrokers' approach. If the market isn't offering the right price on a stock, just walk away.

These boots are made for walkin'
To decide whether you should walk away from a potential stock purchase, you first need to determine what the stock should be worth based on the intrinsic value of the company, which can be measured in most cases using discounted cash flow analysis. Put simply, a DCF model estimates future cash flows generated by the business and determines what those future cash flows are worth today.

To be sure, estimating a stock's intrinsic value is both art and science, but establishing even a range of potential fair values is better than flying by the seat of your pants. Overpay too often for your stocks, and you could be out of business as quickly as an unskillful pawnbroker.

When the market's rallying off generational lows, it might seem that bargain stocks are everywhere, but investors need to take account of each stock separately and avoid the plethora of huge value traps that have popped up in recent months.

It doesn't take a market genius, for instance, to regard the 300%-plus rallies since March in unprofitable mortgage insurers like Radian Group (NYSE: RDN), PMI Group, and MGIC Investment (NYSE: MTG) with some definite skepticism.

Is it cheap or not?
With the assistance of the Motley Fool Inside Value discounted cash flow calculator, we can begin to develop an idea of a stock's fair value. In each valuation, I discounted free cash flow estimates by 12% and assigned 3% terminal growth.

Here are five results:

Data provided by Capital IQ, as of Dec. 7.

Please note that none of these should be taken as stock recommendations or official valuations. Still, they begin to give us an idea of which stocks are worth researching and which ones we should simply avoid.

The current price of Reynolds American provides a better margin of safety than the others do, so it's more likely that even if it falls short of already low analyst expectations, you'd still have a decent shot at breaking even on your investment. On the other hand, if Lowe's, Yahoo!, Google, and Colgate-Palmolive don't live up to the market's expectations, the downside risk is greater.

If I were the pawnbroker, I'd make a deal on Reynolds American at current prices and might consider Lowe's and Google, but would walk away from Yahoo! and Colgate-Palmolive. Sure, Yahoo! and Colgate-Palmolive are good companies with good stories, but at these prices? Sorry we couldn't do business.

Nothing personal, just business
Maintaining price discipline is the key to long-term investing success. Overpaying for a stock with a great story is a quick way to become jaded -- and broke. Instead, before making a buy decision, ask yourself, "Will I be able to sell this stock in three, five, or 10-plus years for a profit?" If you're unsure, just walk away.

Yes, you might make some decisions that, in hindsight, you'll know were wrong, but by doing the proper due diligence before buying, you'll learn from your mistakes, and in most cases save yourself from massive losses.

In April 2008, our Motley Fool Inside Value team saved itself from losing a big gain when it sold Cimarex Energy at $63 a share on valuation concerns. It was a smart move; in the subsequent market decline, Cimarex fell all the way to $15.35. Instead of a 50% loss, the team locked in a 182% gain. Then, in March 2009, the team maintained price discipline and re-recommended Cimarex around $24. It's currently trading for around $48.

If you'd like some help finding more stocks trading at deep discounts to their fair value, take 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 originally published Aug. 27, 2009. It has been updated.

Fool analyst Todd Wenning didn't realize pawn shops have been around for thousands of years -- thanks, History Channel! He does not own shares of any company mentioned. Google is a Motley Fool Rule Breakers pick. Lowe's and Cimarex are Inside Value selections. The Fool's disclosure policy drives a hard bargain.