Sure, we all feel like geniuses now, right? We stuck out the worst economic crisis since the Great Depression, and we've enjoyed fat and happy double-digit gains ever since the market hit bottom last March.
There's surely more to come, right? Right?!
Survey says ...
Who knows? We Fools pride ourselves not on making market calls, which are a great way to get slapped silly by the market's invisible hand. Instead, we take pride in 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 both 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 nut 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 Google (Nasdaq: GOOG) and Research In Motion (Nasdaq: RIM). Back in June 2008 -- shortly after reaching a fat and unhappy P/E greater than 60 -- RIM began a precipitous slide that saw the company's shares shed more than 50% of their value. Google suffered a similar fate when its above-40 P/E bubble burst around the same time.
Could investors have seen that coming? Not with perfect clarity, of course. 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.
Both companies have recovered since their respective sell-offs, and while each currently trades with far more modest multiples, they're not quite modest enough for my taste: both companies' stock prices hover above 20 times the cash flow they've generated over the last 12 months.
As the history lesson I've just sketched illustrates, a little valuation discipline can go a long way. When an all-but-inevitable market pullback arrives, such highfliers can be sitting ducks -- and future bargains, at least in relative terms.
Good companies. Lousy investments?
Along those same lines -- and following market-besting run-ups over the past 12 months -- Nike (NYSE: NKE) and Starbucks (Nasdaq: SBUX) could be cruising for proverbial bruisings, too: Both are tethered to consumer spending, a key macro metric whose recent uptick owes more to rising fuel costs than to the kind of free-and-easy discretionary spending that fuels these firms' bottom lines.
Indeed, Starbucks saw revenue flatline over the past year, while Nike's ticked down to the tune of 5%. The companies' valuations look rich, too, with both trading at forward P/Es around 20.
The Street set has similarly high hopes for high-end retailer Tiffany (NYSE: TIF), which sports a forward P/E of more than 20 times analyst earnings expectations. (The company also "sports" a CEO whose total compensation increased by roughly 66% last year. Talk about high-end!) The Street's rosy scenario could evaporate on contact with reality if the firm's next quarterly earnings report -- due this time next month -- fails to surpass the year-ago period's ridiculously easy comps.
The good news is that if, like me, you think the market's admittedly impressive rally has a pretty rickety underpinning, a good many long-haul overachievers are trading on the cheap. As a group, high-quality large-caps such as Chevron (NYSE: CVX) and Coca-Cola (NYSE KO) haven't gone nearly as far as fast as junkier fare -- and those two companies in particular warrant close inspection right now. If the economy turns south, their rock-solid financial health -- both boast low debt-to-equity ratios, a key balance-sheet barometer -- will command a flight-to-quality premium.
Moreover, when (not if), the rally cools, investors will favor firms that can make them wealthier in ways beyond mere stock-price appreciation. With dividend yields above 3%, both Chevron and Coke -- both of which trade with below-market P/Es -- are poised to do just that.
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 rests squarely on rock-solid companies trading for a song. Click here to take the service for a completely free 30-day test drive.
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 Rule Breakers pick. Starbucks is a Stock Advisor selection. The Fool has a strict disclosure policy.
