NEW YORK (CNN/Money) - 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.
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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 their 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 is credible.
Profiting from low-P/E stocks is easier because there are benchmarks to guide you. These days, for example, the average P/E for the S&P 500 is around 17. So any stock with a P/E below 17 qualifies as a possible value stock.
Stocks can languish with low P/Es for a long time, however, so it's best to look for a company that also has moderate earnings growth. That combination is 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 8 percent to 14 percent range).
The simplest way to tell when GARP stocks are a good value (rather than just cheap) is to compare their P/Es to their earnings growth rates (called the PEG ratio, or P/E to Growth). Stocks with P/Es lower than their growth rates are very cheap. They're also rare, although you can find a few in the current market.
For stocks with significant dividend yields, it's helpful to gauge the potential total return by adding the yield to the earnings growth rate -- and then divide the P/E by that total return figure. The ratio that results is a fairer measure than a conventional PEG ratio.
Financial stocks, such as Citigroup and J.P. Morgan Chase, for instance, offer yields over 3 percent. Although the banks' earnings growth rates are only in the 10 percent to 12 percent range, their generous dividends boost the total return potential to 13 percent or more. That return is higher than the banks' P/E, which means that the stocks are trading at ratios below 1.0 and are therefore very attractive.
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 dividend yield) totaling more than the market's 12 percent long-term historical average.
If your stock doesn't qualify, it's smarter to cash out and use your profits to buy another unappreciated gem.