How to Find Value in a Cheap Market

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Created on Friday, 03 September 2010 15:41

Written by Sara Nunnally, Editor, Smart Investing Daily

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Stocks are cheap... There's no question about that. Early this week, the S&P 500's components were trading at an average 11.7 times earnings. That's almost, reported the Associated Press, as low as they were last year when they hit a 12-year low!

But just because something's cheap doesn't mean it's good... Kind of like single-ply toilet paper: you just don't buy it.

In looking at recent history, though, it's hard not to start snapping up stocks. Last year, in March 2009 when the S&P 500 multiple was at a similar level, stocks shot up 80%. Is it possible another surge in the stock market will happen now with P/E ratios so low?

Sure, it's possible, but that doesn't mean you shouldn't be selective with your picks. We've seen a number of stocks across this market lose that whole run up from last year.

And consider this from the AP:

An April study by McKinsey & Co. of analyst projections over 25 years showed they are almost always too optimistic. On average, analysts estimated that profits would grow at 10 percent to 12 percent annually -- almost twice as much as they actually did.

That makes it important to really know what you're buying...

So how do you find value in a cheap market?

Price-earnings ratios are just one piece in the puzzle. A struggling market can make anything look like a deal, so that figure needs to be part of a number of statistics you take into account.

In general, though, P/E ratios for undervalued stocks are lower than their industry's average or major competitors.

But let's look at some other figures that help determine if a stock is undervalued or just really cheap.

General Guidelines for Finding Value

Most value investors also look at things like dividends, book value, cash flow, PEG and debt-equity ratios. This isn't a complete list, either.

There are some general guidelines that value investors follow. An Investopedia article, titled "5 Must-Have Metrics for Value Investors," outlines them:

• Price-Earnings Ratio
• Price-Book Ratio
• Debt-Equity
• Free Cash Flow
• PEG Ratio

Of course, you also need to know what you're looking for in each of these figures. Some standard guidelines say the P/E ratio of a "value" company should be at the lowest 10% of all equity securities. Another guideline is that the PEG should be less than one, as should the debt-equity ratio.

There are others who talk about share prices being no more than two-thirds of the company's intrinsic worth, assets at two times current liabilities, and earnings growth at least 7% a year over the last decade.

There are a lot of parameters, and applying them all in today's market really narrows your possibilities.

So let's stick with these five factors in determining a value stock and dive into the markets...

(By the way, investing doesn't have to be complicated. Sign up for Smart Investing Daily and let my fellow editor Jared Levy and I simplify the stock market for you with our easy-to-understand investment articles.)

Diving Into the Markets

In a quick analysis of two well-known tech companies, we'll find out which a better value. Here's the side-by-side:

Microsoft has a lower P/E ratio and a lower debt ratio. MSFT also has a higher free cash flow, and a PEG that's still below one.

But let's take a closer look at the price-book ratio, and what it means for these two companies.

This ratio tells you how much investors are willing to pay for a company's assets. It's calculated by dividing the share price by the company's net assets, which don't include intangible things like patents or proprietary technology.

In both Apple and Microsoft, this value is pretty high. A guideline for value stocks is a price/book ratio below 1.5.

That said, in our comparison, Microsoft is a better value... and compared to the personal computer industry, whose price/book value is 6.09 with an average P/E ratio of 20, it's comparatively undervalued.

MSFT is still about 2% lower than prices were a year ago, but we haven't seen a true bottom yet after the swift rise through last year and the rounding over of this year. A sure bottom might see prices climb back above $24 for starters, but you might want to see if MSFT can break through the $26 level to see a trend higher.

Here's another comparison.

ConocoPhillips clearly trumps Exxon across the board... even with PEG, which is short for price/earnings to growth. Take the P/E ratio and divide it by annual earnings per share growth... Like P/E ratios, the lower the number the more undervalued the company could be.

We see that Exxon has a higher free cash flow, which is good... But with COP's figure well positive, that's not a concern. The free cash flow accounts for how much money a company has left after any capital investments. Had COP's free cash flow figure been in the millions instead of billions, we might have had some cause for concern.

Compared to the major integrated oil and gas industry with an average P/E ratio of 10.20 and price/book value of 1.55, ConocoPhillips is undervalued.

ConocoPhillips has seen a significant pullback in the stock since May's high of $60.53. A dip below $52 makes COP a buy in my book.

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