The Worst Way to Invest in Today's Market

As with any market, the short answer is, "It depends." More specifically, it depends on what type of growth you're expecting from the companies you research.

Do you see a butterfly? Or a moth?
Growth estimates for corporate earnings vary widely among Wall Street analysts, and thus produce very different valuations for stocks. Consider the case of Baidu (Nasdaq: BIDU), for which eight analysts' estimates for long-term earnings growth range from 18% all the way up to 63%. Analyst price targets reflect these discrepancies, and range from $170 to $455 a share (while the stock currently trades around $377), predicting anything from a possible loss of 55% to a gain of 21%.

There's obvious disagreement in the analyst community about how fast Baidu can grow in the coming years. Whose estimates should you trust?

The best policy is not to fully trust any of them. Instead, use their consensus as a starting point for your own estimates. See, Wall Street estimates have proved extremely optimistic on average. And as a study by Patrick Cusatis and J. Randall Woolridge of Pennsylvania State University showed, their five-year growth estimates are off by nearly 40% on average.

In other words, relying on Wall Street estimates to value companies is a quick way to destroy your portfolio. These days, you simply can't afford to let that happen again.

So don't let it
Based on the findings of the Cusatis and Woolridge study, a simple rule of thumb when making conservative growth estimates is to take the median analyst estimate and cut it in half. If the stock's still a value at that point, it's worth further research.

Looking at a number of the market's more popular large caps, along with current Wall Street estimates and the assistance of the Motley Fool Inside Value discounted cash flow calculator, we can begin to see where true market values may lie. In each valuation, I discounted free cash flow estimates by 10% and assigned 3% terminal growth.

Source: Capital IQ, as of Sept. 24, 2009.

Please note that none of these should be taken as stock recommendations or official valuations. Still, these back-of-the-envelope calculations reveal some intriguing research opportunities.

Based on these rough valuations, Amgen, Honeywell, and Hewlett-Packard appear undervalued, even if they perform only half as well as the Street predicts. Target and 3M are also worth researching at these prices, but they have smaller margins of safety. Colgate-Palmolive, on the other hand, looks more fairly valued today. Before you consider making an investment in any of these companies, it's important to run your own valuation and determine the level of risk inherent in each one.

Selectivity is key
There are still some tremendous values out there, but relying on Wall Street earnings estimates to determine those values is the worst way to invest in today's market. If you want to begin to rebuild your portfolio from the recent market mess, now's the time to be more conservative with your outlook. Cautious estimates will not only help you find today's true market values, but also help protect you from being too wrong if something unexpected happens at the company or with the economy.

If you'd like some help finding more stocks trading at deep discounts to their fair value, you should consider a free 30-day trial of our Inside Value service. The Inside Value team scours the market for the best deals each month and shows you how to better analyze the stocks in your portfolio.

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© 2009 UCLICK, L.L.C.