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Good and Bad 'Value' Stocks

There's a big difference between cheap and undervalued.

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One of the most crucial distinctions in investing is the one between a cheap stock and an underpriced stock. Enron (ENRNQ) certainly was cheap before it went bankrupt. WorldCom (WCOM), a struggling telecom, is cheap now. And Ford Motor (F), a mature cyclical, has been cheap for decades. Most cheap stocks are cheap because their businesses are sputtering, which is another way of saying you get what you pay for. What most of us want to buy is not a cheap stock, but an undervalued stock.

It's easy to find cheap stocks: Just look for relatively low price multiples--a low P/E, for example. The Morningstar Style Box--especially in its reincarnated version--is a good barometer of cheapness. The stocks in the far left column of the Style Box are those that have low ratios of price to forward earnings, price to book, price to sales, price to cash flow, and price to dividends. If you want to screen for stocks on which the market pins low price multiples, screening on the value column of the Style Box is a handy, reliable way to do it.

An undervalued stock, on the other hand, is one whose price is less than the present value of a company's future free cash flows. These are the true bargains. Unfortunately, it's a lot harder to find these. You can't just run a screen on P/E ratios or use the Style Box.

Haywood Kelly, CFA does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.