When searching for undervalued companies, investors commonly rely on the most tried-and-true financial measures: Price/Book, Price/Earnings, Price/Cash Flow, etc. To be sure, such traditional valuation metrics can be useful, but they only tell part of the story.

Potential Drawbacks
For example, a low Price/Sales ratio means little when a company has razor-thin profit margins and is having trouble converting those sales to profits. Meanwhile, a single-digit trailing P/E ratio might look good on paper, but it can be misleading if the company's earnings are forecast to fall sharply in the years ahead.

Even when properly applied, the aforementioned valuation ratios are extremely subjective and they can only tell us how expensive a stock is relative to something else. For example, a company might look "cheap" when stacked alongside its peer group, but what if the entire industry is overvalued?

And let's not forget, in many cases a stock that appears sharply undervalued might belong to a deeply troubled company that deserves its rock-bottom price tag. Therefore, investing solely on the basis of price can be a recipe for mediocre performance.

Part of the problem is that ratio-based analysis often leads to inconclusive results. To help illustrate this point, let's review the example below. At first glance company "A", which is trading at 15 times last year's earnings, might look like a bargain compared to company "B" at 20 times trailing earnings.

However, let's take a deeper look.

As the table shows, company "B" likely belongs to a high-growth industry, and the stock is trading at a 50% discount to that of its competitors. Meanwhile, company "A" operates in a mature business and is changing hands for a 50% premium to the rest of its industry group.

At the same time, company "B" is selling at the low-end of its own historical P/E range, versus the high-end for "A". Finally, company "B" is expected to deliver double the earnings growth of company "A" in the years ahead.

Clearly, the decision is not so cut-and-dried now; other considerations must be made. Based on these additional factors, it now appears as if company "B" might be the more undervalued stock -- despite its higher P/E.

So now the question remains, is company "B" just cheaper than "A", or is it actually undervalued and worthy of additional consideration? Well, the next step might be to use a forward-looking ratio like PEG (price/earnings to growth). Currently, the company's P/E matches its expected growth rate, which yields a PEG of 1.0.

Does this represent an undervalued stock? Again, that simple question has no definitive answer. According to conventional thinking, any firm with a PEG of 1.0 or below is considered underpriced. However, is it really prudent to base your portfolio decisions on loose "rule-of-thumb" type methodology?

Discounted Cash Flow (DCF) Modeling
Our point is not to discredit traditional valuation techniques. Like many other analysts, we have relied on them in the past and will continue to do so in the future. Rather, we are merely pointing out that they have their limitations, and assigning value using ratio-based analysis exclusively is a flawed approach.

Going back to company "B", we may or may not consider investing in the company at this point. After all, the firm's P/E of 20 and its PEG of 1.0 don't really tell us whether the firm is actually undervalued.

However, what if we had a reasonably accurate way to measure a firm's true intrinsic value? By employing this methodology, what if we knew the shares were currently trading at $25, yet their estimated fair value was $50? In this case, we would have removed much of the doubt, and the company would indeed be well worth a closer look. Our mission is to scour the market in search of such half-priced stocks.

The difficult part of this process is to quantitatively determine why company "B" is worth $50 per share. To accomplish this task, we place a great deal of emphasis on a superior analytical tool -- discounted cash flow models.

At its core, ownership in a company entitles shareholders to a stake in the profits generated by the firm over time. Because GAAP earnings are subject to manipulation and can be distorted by depreciation, goodwill writedowns, and a host of additional non-cash charges, we believe that cash flows are a much truer gauge of a firm's true profitability.

Therefore, to determine a fair value price for a company, we simply project the amount of operating cash flow that the firm is likely to produce in the years ahead. From there, we determine how much those future cash flows are worth in today's dollars by discounting them back to the present at a rate sufficient to compensate investors for the risk taken. Finally, we then divide that figure by the total number of fully-diluted shares outstanding to arrive at our per-share fair value estimate.

An extremely scaled-down version
Suppose that a "club" offered to pay each of its members $108 in precisely one year. Next, assume that you are fairly confident of being able to earn an 8% rate of return over the next twelve months on your money. Based on those assumptions, how much would you pay in order to "join" this club today?

Well, if you invested $100 dollars anywhere else, then based on the 8% rate of return, you could reasonably expect it to be worth the same $108 in one year's time. Therefore, it would be a poor financial decision to pay one penny more than $100 to join the club. Why? Because your annual return from such an investment would be less than 8%. However, it would be profitable to join the club for anything less than $100, as it would offer a higher return than you could get elsewhere.

In this simplified example, the club (company) is expected to pay its members (shareholders) pro-rata cash flow of $108 in one year's time. Thus, based on the required rate of return (discount rate) of 8%, the breakeven mark (fair value) for this investment would be $100.

Thus, if memberships were selling for $90, then they would be "trading" at a 10% discount to their fair value -- and thus probably worth buying.

Of course, in the real world, there is no guarantee that a company can deliver on its cash flow projections. As such, we demand a premium to the risk-free interest rate. The riskier the company, the larger the discount rate we apply. Also, our valuation models look much further out than just the next year.

Though this description sounds fairly straightforward, discounted cash flow modeling is actually a complex process that incorporates assumptions regarding short and long-term growth rates, capital expenditures, weighted average cost of capital (WACC), and many other factors. Naturally, such variables are impossible to predict with exact precision, so we err on the side of caution by using deliberately conservative growth rates and other figures. Of course, if the companies we profile overshoot our forecasts, then their upside potential will be even greater.

Putting it all together
Calculating fair values according to the discounted cash flow method can be an exhaustive process -- but we don't stop there. After narrowing down an initial pool of thousands of potential stocks, only the most deeply undervalued qualify for more extensive analysis. Of this group, we then combine our work with additional fair value calculations determined by several of Wall Street's most prominent firms to arrive at our final fair value estimate.

With all of the above in mind, in each and every issue of our premium value investing newsletter -- Half-Priced Stocks -- we make certain to list our fair value estimate for every company we profile. In addition, we bring you a table of ten companies in our coverage universe that are trading at some of the steepest discounts to their fair value. Considering that fair value incorporates future growth rates and other fundamental factors, each company that appears on this list probably merits additional research.

Without further delay, in the table below you'll find our most recent listing of ten of the most undervalued stocks in our coverage universe . . . 

Editor's Note:  Throughout the remainder of this article, co-editors Nathan Slaughter and Paul Tracy provide a table of ten stocks that are now trading at some of the largest discounts to their estimated fair value. To view the remainder of this article, you'll need to subscribe to our premium value investing newsletter -- Half-Priced Stocks. Please visit one of the following links to continue . . .

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