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By Joe Escalada

A stock’s price alone is not enough information to determine how undervalued or overvalued it is. Sensible investors compare the share’s market price to some measure of its intrinsic value. If the price is lower than the value of a share, then it’s a good buy. If the price is higher than the intrinsic value of the share, then investors should wait.

A small sample of five stocks will demonstrate how price itself might fail investors. Consider LSI Corporation (NASDAQ:LSI), Time Warner Inc. (NYSE:TWX), Macy's, Inc. (NYSE:M), United States Steel Corp. (NYSE:X), and Renren Inc. (NYSE:RENN). These are very different companies trading at very different share prices:

Ticker

$/Share

P/E (ttm)

P/E (forward)

P/S (ttm)

P/B

Dividend Yield

LSI

5.66

40.43

6.8

11.32

2.55

0.00%

M

30.36

11.2

9.6

0.5

2.18

1.32%

RENN

4.28

N/A

214.0

6.73

1.36

0.00%

TWX

33.61

12.73

10.6

1.18

1.1

2.80%

X

25.68

N/A

10.1

0.19

0.89

0.78%

Even though the share prices of M, TWX, and X have the higher share prices that LSI and RENN, they are in fact cheaper, according to relative valuation metrics. Investors who buy M, TWX, and X are buying more sales and earnings per dollar than investors who invest the same amount in LSI or RENN. Clearly, investors ought to look at price-to-earnings ratios, price-to-sales ratios, and price-to-book ratios to appreciate whether a stock is a deal at current market prices.

Moreover, investors can try to model the intrinsic value of a share and compare it to the market price. This analysis requires assumptions about the future performance of a firm, and is a bit trickier.

On an absolute basis, are the current prices of these companies cheap or expensive? There are a few ways to attack this question on the basis of returns. An investor could consider how future growth would decrease the price to earnings ratio in the future, essentially betting that valuations will improve with earnings growth. The investor would be able to sell the stock for a profit only if buyers were willing to pay for the stock at reasonable multiples. If investor sentiment had soured, the investor would either have to hold the stock or take a loss.

We can model this process using a three or five year holding period since above-average growth estimates are not reliable further out. A price to earnings multiple of 13 is a little lower than the historical market average, and will be assumed as a conservative sale valuation. Earnings growth over the holding period will be taken as the lesser of earnings growth over the last five years and earnings growth projected by analysts for the next five years. Using the smaller of the two will lead to conservative estimates. These growth rates are used to calculate terminal price to earnings ratios, that is, price paid today divided by earnings at the end of the holding period.

Since RENN and X suffered losses over the last twelve month, their forward P/E estimates were generously substituted as an initial price-to-earnings ratio. The results follow:

3 Years Growth

5 Years Growth

Ticker

g (past)

g (future)

Terminal P/E

Annualized Return

Terminal P/E

Annualized Return

LSI

-0.4%

12.0%

40.9

-31.7%

41.2

-26.4%

M

-8.9%

10.7%

14.8

-3.8%

17.8

-6.9%

RENN

0.0%

31.6%

214.0

-60.7%

214.0

-52.6%

TWX

7.1%

13.9%

10.4

8.8%

9.0

9.4%

X

-25.8%

5.0%

24.6

-19.0%

44.7

-25.1%

At current prices, only TWX compensates investors the risk of owning a stock. The other stocks would require more enthusiastic projections to provide appropriate returns. Before buying shares of the other four companies, investors ought to wait for either share prices to drop, their outlooks to improve, or both.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: 5 Stocks Under $35: Which Are Undervalued?