Forget stock price, focus on value

Not all stocks that have soared recently are frothy. Some, in fact, are surprisingly cheap.

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By Pat Dorsey, director of equity research for Morningstar

Pat Dorsey is the director of equity research for Morningstar.
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(Money Magazine) -- It's all too easy to think that a stock that has risen sharply is no longer a bargain -- or conversely that shares that have been cut in half must be a good deal. If only investing were that simple.

I learned this the hard way a few years ago. In the summer of 2006 I bought some MasterCard stock after the credit card company went public. In the first few months the shares moved up steadily, but then they rocketed from $70 to $90 in just a week's time. Since I was on an overseas business trip with little time for research, I reflexively sold a chunk of my holdings.

Dumb move. As it turned out, the company's profit margins were growing faster than I had anticipated -- boosting MasterCard's value -- and the shares topped out at $320 a couple of years later. If I had paid more attention to the value of the business, rather than the price of the stock, I might have held on.

Price bias. This is a mistake investors make all the time. That's because every day we're bombarded with stock prices, yet no one publishes a ticker tape of business values. Behavioral-finance experts have a term for this: availability bias. We place more weight on prices than we rationally should simply because this type of data is more available than others.

There are ways to avoid this trap. First, if a stock sounds interesting, look at its price chart last. This will help you think about the company more dispassionately. Second, try to put a rough value on the underlying business before you buy the stock -- and update that estimate as new information such as earnings reports or a change in the business environment becomes available.

Now, when I say "put a rough value on the business," you may think that I'm asking you to build a complicated financial model. Nope. You can do this with a simple calculation that looks at what a company earns in average years -- not in unsustainably good or bad periods -- and considers what those profits are worth in terms of a price/earnings ratio.

How the numbers work. Let's use American Express (AXP, Fortune 500) as an example. Over the past several years its annual earnings ranged from $2 a share to $3.39. So let's ballpark that and say it averaged profits of $2.75 a share. Meanwhile, the stock has historically had a P/E of 20. Multiply $2.75 by 20, and you get a rough value of $55, well above its current price.

Needless to say, this is a back-of the-envelope calculation (at Morningstar, our process for determining stock values is a tad more complex). Moreover, new developments -- for instance, if a firm sold off a huge chunk of its business -- could render historical earnings figures obsolete. And remember that there are no guarantees the market will quickly bid up a stock to reflect its value.

Yet for long-term investors, this is a useful exercise to help you figure out if a stock is worth buying and -- just as important -- holding.

Pat Dorsey is the director of equity research for Morningstar. To top of page

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