Value Your Stocks Thoughtfully

Value investors always seek stocks that are trading below their intrinsic value, especially in a bear market. So, when you see a company whose financials suggest that its shares are a huge bargain, should you hesitate to jump right in and buy? How low should you "set the bar"?

Let's remember, first-quarter 2009 earnings from across the market spectrum are so far coming in better than expected -- largely as a result of a very low "bar". The results have some people now uttering economic buzzwords like "deceleration," "signs of recovery," "the bottom" and the very precise "less bad".

More than half the companies in the S&P 500 have reported their first-quarter results. Of those, 65 percent beat analyst expectations. But overall, results were still down roughly 30 percent from a year ago.

"It's bad -- but it's not as bad as we thought," said Bob Doll, global chief investment officer for equities at investment manager BlackRock.

The quarterly results hint at signs of recovery, but the picture remains very murky. It's unclear if the banks at the heart of the meltdown are seeing a better results because the worst is over or due to the benefit of new accounting measures.

And some retailers, who are the litmus test of consumer spending, say the worst in their earnings reports may be over but only due to tighter inventories, job cuts and store closures. There are clearly tough economic times and it has been rough going for investors.

Of course, the bear market has caused many stock valuation measures to plummet. But lately, a huge number of stocks are trading at extremely attractive levels -- levels that imply that buyers might be getting something for nothing.

Is that a symptom of just how irrational the bear market correction has become? Or are these apparently attractive prices actually a value trap waiting to snare unsuspecting investors?

Considering Book Value

A company's book value is one of the simplest measures of a company's worth. All you need to calculate book value is a balance sheet. By taking the total value of a company's assets and subtracting out debt and other liabilities, the remaining amount should represent the equity that shareholders own in the company.

There's no shortage of stocks trading at prices below their book value per share right now. Here's a sampling:

Stock &... Price May 1 Book Value Price-to-Book Ratio

• NYSE Euronext (NYSE: NYX) 23.30 25.31 .92
• Dow Chemical (NYSE:DOW) ... 15.70 14.62 1.09
• Morgan Stanley (NYSE: MS) 25.82 30.24 .85
• Alcoa (NYSE: AA) 9.69 12.71 . 76

Source: Yahoo! Finance

The sages at Motley Fool (fool.com) point out that investors who trust book value as accurately representing the value of a company's assets and liabilities would be buying these stocks hand over fist, scooping up investments trading at pennies on the dollar in hopes of an eventual recovery.

What's wrong with that picture? Obviously, there's a catch. Here, it's the assumption that book value isn't just a figment of an accountant's imagination. In some cases,that's pretty questionable, especially right now.

For instance, take a closer look at NYSE Euronext. Of its roughly $14 billion in assets as of the end of 2008, goodwill and other intangible assets composed over $9.8 billion. Given the rate at which many companies have been taking impairment charges to goodwill lately, it's highly probable that investors aren't giving full weight to that asset on the balance sheet.

If you take out goodwill and other intangibles and consider only the tangible assets on the books, you get a much different picture of the company. Tangible assets are actually worth less than outstanding liabilities, making it clear that at least on that basis, the company is far from the bargain it appeared to be when looking solely at book value.

Other industries have other issues. Industrial companies like Dow Chemical have substantial amounts of assets tied up in plants and equipment, where book value may not accurately reflect current values. And with financial stocks, we know all too well how uncertain the values of some of their toxic assets have turned out.

Stay Out of the Book Value Trap

The book value trap is just another example of how simple valuation methods can lead you astray. But that doesn't mean that book value is useless. If you know how stated book value distorts the actual intrinsic value of a company's assets, then you can adjust for it and make smart conclusions about which stocks still look attractive.

Moreover, you'll sometimes find that book value actually understates the true value of an asset -- especially one that has been held on the books for a long time.

Value investing remains a lucrative way to profit from the market's inefficiencies. But you can't simply look at a single measure of valuation and draw conclusions from it. Book value is a useful metric, but it's only one of many tools that experienced investors use to decide whether a stock will make a strong value stock.

By incorporating book value analysis with other valuation methods, such as those based on earnings, revenue, and cash flow, you'll be more certain that the stocks you choose really are great values.

Do First Quarter Results Hint at Recovery?

Perhaps they do.The quarterly results seem to hint at signs of recovery, but the picture remains very murky. It's unclear if the banks at the heart of the meltdown are seeing a better results because the worst is over or due to the benefit of new accounting measures.

And some retailers, who are the litmus test of consumer spending, say the worst in their earnings reports may be over but only due to tighter inventories, job cuts and store closures. Even within industries, the reports were a mixed bag.

In the technology sector, one of the highlights came from Apple Inc. (Nasdaq: AAPL), where strong iPhone sales helped boost quarterly profit 15 percent. But more often, the recession took its toll, even on names like Google Inc (Nasdaq: GOOG). The company's profit rose 9 percent for the quarter because of cost-cutting, but revenue grew at the slowest rate in Google's history as a public company.

If you looked at Apple's and Google's book value per share you wouldn't begin to understand why these two stocks trade at the prices and high earnings multiples that they do.

Bob Doll from Blackrock noted that across the board, most of the companies that beat expectations did so through cost reductions rather than showing top-line growth.

In other words, the better results came from job cuts and store closures during the quarter, rather than more cars and refrigerators being sold.

All the more reason to make sure that the price-per-share of the stocks you own and hold accurately reflect the times and circumstances that we are living in now and will continue to experience for many months to come.

Disclosure: I do not currently own any of the stocks mentioned in this article.

Comments

[Stez:]

There was a study on Seeking Alpha demonstrating that low Book Value stocks were under performing the market.

Like low PE stocks taken out of context they can lead to value traps.

Generally stocks with good cashflow and strong returns on Investment outperform then market.

It's important point to make isolating single metrics can lead to real problems in performance.

May 04 12:58 PM

[Marc Courtenay:]

Appreciate your comment. I couldn't agree with you more.


On May 04 12:58 PM Stez wrote:

> There was a study on Seeking Alpha demonstrating that low Book Value
> stocks were under performing the market.
>
> Like low PE stocks taken out of context they can lead to value traps.
>
>
> Generally stocks with good cashflow and strong returns on Investment
> outperform then market.
>
> It's important point to make isolating single metrics can lead to
> real problems in performance.
>

May 04 08:00 PM

[Ryan Vanzo:]

Thanks again Marc. Although I happen to like NYX, I see the point your trying to make.

People always ask me how you can tell stocks are 'cheap' and which ones are winners. As you've demonstrated, there are not only thousands of metrics, but there are problems with all of them. It's always frustrating teaching a valuation metric only to say at the end...."but this number is almost always inaccurate or misleading."

Thanks again for showing that everyone needs to use various metrics and there are problems with every one of them.

May 10 03:46 PM