Walk Away From These Stocks

And no, I didn't find this out by trying to hock my grandfather's
watch. This pawn shop is featured in a new History Channel show called Pawn Stars. As a history buff -- and an investor -- I've quickly become addicted to the show.

It's amazing what some people bring in either for sale or to pawn,
like an 1849 Colt revolver and Salvador Dali proofs. Everyone has a
great story to tell -- they're trying to get top dollar, after all. But
for the pawnbrokers, a good story isn't enough. The price also has to
be right.

See, if the pawnbroker gets all googly-eyed about a great story and
overpays for it, he'll be unable to make a profit when he tries to sell
the item in question. A string of mistakes like this will quickly put
him out of business. That's why, if the price isn't right, a successful
pawnbroker will simply walk away -- no regrets.

As investors, we could take a page from the pawnbrokers' approach.
If the market isn't offering the right price on a stock, just walk away.

These boots are made for walkin'
To decide
whether you should walk away from a potential stock purchase, you first
need to determine what the stock should be worth based on the intrinsic
value of the company, which can be measured in most cases using discounted cash flow
analysis. Put simply, a DCF model estimates future cash flows generated
by the business and determines what those future cash flows are worth
today.

To be sure, estimating a stock's intrinsic value is both art and
science, but establishing even a range of potential fair values is
better than flying by the seat of your pants. Overpay too often for
your stocks, and you could be out of business as quickly as an
unskillful pawnbroker.

When the market's rallying off generational lows, it might seem that bargain stocks are everywhere, but investors need to take account of each stock separately and avoid the plethora of huge value traps that have popped up in recent months.

It doesn't take a market genius, for instance, to regard the rallies in stocks like MGM Mirage (NYSE: MGM) and AIG (NYSE: AIG) (300%-plus since early March!) with some definite skepticism.

Is it cheap or not?
With the assistance of the Motley Fool Inside Value discounted cash flow calculator,
we can begin to develop an idea of a stock's fair value. In each
valuation, I discounted free cash flow estimates by 12% and assigned 3%
terminal growth.

Here are five results:

Data provided by Capital IQ, as of Nov. 3.

Please note that none of these should be taken as stock
recommendations or official valuations. Still, they begin to give us an
idea of which stocks are worth researching and which ones we should
simply avoid.

The current prices of Texas Instruments and 3M provide a better
margin of safety than the other three do. It's more likely that even if
the former group falls short of analyst expectations, you'll still have
a decent shot at breaking even on your investment. On the other hand,
if Nike, salesforce.com, and American Eagle don't live up to the
market's expectations, the downside risk is greater.

If I were the pawnbroker, I'd consider making a deal on Texas
Instruments and 3M at current prices, but would walk away from the
others. Sure, Nike, salesforce.com, and American Eagle are great
companies with great stories, but at these prices? Sorry we couldn't do
business.

Nothing personal, just business
Maintaining
price discipline is the key to long-term investing success. Overpaying
for a stock with a great story is a quick way to become jaded -- and
broke. Instead, before making a buy decision, ask yourself, "Will I be
able to sell this stock in three, five, or 10-plus years for a profit?"
If you're unsure, just walk away.

Yes, you might make some decisions that, in hindsight, you'll know
were wrong, but by doing the proper due diligence before buying, you'll
learn from your mistakes, and in most cases save yourself from massive
losses.

In April 2008, our Motley Fool Inside Value team saved itself from losing a big gain when it sold Cimarex Energy
at $63 a share on valuation concerns. It was a smart move; in the
subsequent market decline, Cimarex fell all the way to $15.35. Instead
of a 50% loss, the team locked in a 182% gain. Then, in March 2009, the
team maintained price discipline and re-recommended Cimarex around $24.
It's currently trading for around $44.

© 2009 UCLICK, L.L.C.