How to Spot Value

SIVY ON STOCKS from money.com
October 13, 2000

How to spot value

No investor wants to overpay for a stock, but value investing has its own
set of rules. Here's a strategy for getting in at the right price.

By Michael Sivy

All investors search for stocks that they think are good values -- after
all, no one wants to overpay. But when stock pickers talk about value
investing they mean something more specific: Looking for stocks that are so
cheap their share prices can rise substantially if investors start viewing
them more positively. That upward revaluation can occur because of
favorable changes in a company's prospects, or even just because of a
change in investor sentiment.

You generally can divide value stocks into two categories -- turnarounds
and stocks with below-average P/Es. The former are companies suffering from depressed earnings because of business problems. If the companies have strong franchises and healthy balance sheets, they will be able to weather
bad times, and earnings should eventually come back. But to invest
successfully in turnarounds, you need to understand the specific nature of
those problems-- whether, for example, they are unique to the company, or the
result of external circumstances. And you need to decide whether
management's plan for turning around the company are credible.

Profiting from low-P/E stocks is easier because there are benchmarks to
guide you. Today, for example, the average P/E for all publicly traded
companies is around 16 and that for the S&P 500 is in the high 20s. So any
stock with a P/E below 20 could possibly qualify as undervalued.

But stocks can languish with low P/Es for long stretches of time, so it's
best to look for a company that also has moderate earnings growth. It's a
combination sometimes called GARP, for Growth At a Reasonable Price. GARP stocks should have most of the same characteristics as growth stocks,
including a strong balance sheet and a record of steady earnings growth
(probably in the 9% to 13% range).

The simplest way to tell when GARP stocks are cheap is to compare their
P/Es to their earnings growth rates (that's called the PEG ratio, or P/E to
Growth). In this market, stocks with P/Es lower than their growth rates are
very cheap. It's also helpful to add a stock's dividend to its earnings
growth rate to get a gauge of potential total return and use that number to
figure the PEG ratio. Auto-parts maker TRW, for instance, has projected
earnings growth of 9% to 10% and a 3% dividend yield. That 12%-plus
potential total return is quite attractive, considering that the P/E is
only 10.

Few depressed stocks stay down forever. And once a value stock rises, you
have to decide whether to continue holding it. Since there won't be much
room for further P/E increases, the stock is only worth hanging on to if it
offers a total return (based on earnings growth and its dividend yield)
totaling at least 14% -- or slightly above the market's long-term
historical average. Otherwise, it's smarter to cash out and use your
profits to buy another unappreciated gem.