Why Stock Prices Don't Matter

Last week, the mighty Citigroup ( C - Analyst Report ) , one of the nation's largest banks and a Dow component, traded briefly below $1 a share before bouncing back to trade at about $1.80.

Other well-known names like Fifth Third Bank (FITB), Las Vegas Sands (LVS), and Ford (F) are all trading under $5 a share.

Even blue chipper General Electric ( GE - Analyst Report ) , the oldest Dow Jones Industrial Average component, fell below $6 a share last week before it rebounded on news that the cut to its credit rating wasn't as severe as feared.

Are these "cheap" stocks an opportunity of a lifetime or a fake-out that will lead to disaster for your portfolio?

"Cheap" Doesn't Mean You Should Own It

Many investors think a stock trading under, say, $5, is "cheap." Citigroup at $1 seems like it's a no-brainer because it really can't go any lower than $1 - can it? In many investors' minds, a blue chip brand like Citigroup can't simply "go away."

And you can buy a LOT of shares for $1. And if it goes to $2, well, then you've doubled your money.

It's easy to see how the gambling mentality takes over with low priced stocks.

Don't be Fooled by Low Share Prices

As this bear continues to roar, don't get sucked into only looking at the price of the stock to determine if it is a bargain.

The stock price is, really, irrelevant. It's all about the earnings in conjunction with the share price.

For example, fertilizer giant Potash of Saskatchewan (POT) appears "expensive" as the stock trades over $75 a share. But analysts estimate 2009 earnings around $10 per share. That would give the company a forward P/E of about 7.

That's pretty darn cheap for a company with a product that will be in demand for years to come. Potash is a Zacks #3 Rank ("hold") stock.

Or consider Microsoft Corporation ( MSFT - Analyst Report ) . Microsoft's stock, trading around $16 a share, is at 1998 levels, split-adjusted.

Is Microsoft "cheap"?

Many investors would answer "no" because the stock's share price isn't at $5 or $10.

But if you look beyond the share price you can find Microsoft's true value.

The company isn't taking any money from TARP. There are no fears of bankruptcy as the company has billions in cash. It has avoided the "problems" that many other companies have encountered in the last year or so with credit and debt.

While estimates are falling, as they are with just about every company right now, current 2009 estimates call for $1.76 per share. That would mean Microsoft is trading around 9 times forward earnings.

For Microsoft, which has historically traded closer to 25 to 30 times earnings, that's pretty darn "cheap".

Earnings in Flux

One caveat to consider when looking for companies that are cheap, or undervalued, is that a lot of companies, and analysts, currently have no idea what earnings are going to look like for the remainder of 2009. Estimates are being cut every day. Some companies have been revising every few weeks.

What looks like a value right now may not be if the company earns less than expected.

Investors should look for companies with solid businesses that will continue to generate cash flow even if things get rockier.

Microsoft, for instance, continues to generate plenty of cash even as its business has slowed. Same with Google ( GOOG - Analyst Report ) , some of the agriculture companies like Monsanto ( MON - Analyst Report ) and cash-rich large energy companies like Chevron (CVX).

Bear Markets Create "Cheap" Stocks

Just because a stock is low priced, doesn't mean it's a value stock. Far from it. Buy earnings, not share price. Look at price-to-earnings ratios and other value fundamentals first. Use the Zacks Rank to find companies with rising earnings estimates. (Rising earnings estimates help ensure that you can really trust that low P/E.)

Sometimes, you will find both a "cheap" and a good value stock.

I used this strategy when I bought Force Protection, Inc. (FRPT), the manufacturer of blast protection vehicles, in the Value Trader 2 trading service last December. At the time, the markets were just coming off of the nasty Nov 20 lows.

Force Protection was a "cheap" stock - trading around $5 a share. But it also had excellent value fundamentals which is what truly attracted me to the company.

It was trading at 13.2x forward earnings and had a price-to-book of 1.3. The company had a solid 1-year return on equity (ROE) of 17.68%. It was also a Zacks #2 Rank ("buy") stock with rising earnings estimates.

I sold the position in Value Trader 2 on Jan 8, 2009 for a 30.71% gain.

"Cheap" or low priced doesn't always equal "value". Buy value first. Your portfolio will thank you.

Tracy is the value stock analyst for Zacks.com. She manages the market-beating Value Trader (closed to new members) and Value Trader 2 trading services.

Her mission is to blend traditional value signals with the timely power of Zacks Rank and find underpriced stocks at the perfect moment - just as the market finally begins to recognize their true worth. This strategy has enabled both value services to crank out double-digit gainers even during this bitter-cold investment winter. Value Trader 2 is accepting new members. In addition to its +30.71% gain on Force Protection described above, it recently closed a +17.72% gain on Knight Capital in 7 weeks and a +20.78% gain on Healthspring in 3 weeks.

(Tracey owns shares of Potash of Saskatchewan.)