How to bottom-fish for stocks

By Jim Jubak

Tired of trying to figure out if the Jan. 22 low was the bottom for stocks? Whether the recent rally will hold or turn into a massive bear trap? Whether to buy now or wait until, well, until who knows when?

Today, I'm going to put you out of your misery and tell you when it's time to buy.

No, I'm not going to call a bottom for the stock market as a whole. (Cue the boo birds.) I don't think anyone is in a position to do that. What I'm going to do instead is show you how to calculate a fair-value price for an individual stock and how to use that to figure out when to buy. This method won't tell you when a stock has hit its absolute bottom, but it will tell you when the price is low enough and the potential return high enough to justify the risk of getting in too early.

It's not about calling a bottom but learning how to bottom-fish.

As guinea pigs, I'm going to use the stocks I picked in my Jan. 29 column, "10 stocks to buy after the bloodbath." And don't worry if you see this column veering toward the dreaded land of Math. I'll do all the hard work and give you fair-value prices for each of these 10 stocks at the end of the column without any heavy lifting on your part.

2 key numbers

The simplest method for figuring out a fair value for a stock starts with the company's projected earnings for the next year and some estimate of a company's appropriate price-to-earnings, or P/E, ratio. Multiply the two and you've got what the stock should be worth in a year.

For example, Wall Street analysts, on average, expect Chevron (CVX, news, msgs), one of my 10 stocks for after the bloodbath, to earn $9.33 a share in 2008. Using the Feb. 15 P/E ratio of 9.4, a fair value for Chevron shares is $87.70. That's above the Feb. 15 close of $83.60 but only about 5% above that price. Holding for the rest of 2008 to make 5% (plus dividends), which is by no means guaranteed in a risky stock market and a slowing economy, isn't my idea of a great investment.

(A target price is different from fair value, in my opinion, because a target price takes into account market conditions, including investor sentiment and momentum. So a target price can be, for periods of a year or less, above or below fair value. You can make money, for example, buying above a fair-value price if the stock market is in a strong bull rally.)

Resting on assumptions

Of course, this method is only as good as the two data points that go into it. The Wall Street earnings consensus can be wrong. In my example, though the average of the analyst estimates is $9.33 a share, the high is $10.75, and the low is $7.85. Somebody's wrong.

Or maybe the P/E ratio is out of line. Chevron trades at a P/E ratio of 9.4 now, but over the past 10 years it has traded at a P/E ratio as low as 7.8 and as high as 76.6.

You can see what a difference these assumptions make by going to the target-price page of the Stock Research Wizard on MSN Money. This tool will plug in the high, low and average earnings estimates and the current company and industry average P/E ratios, and then calculate a target price. The resulting prices for the next year range from $74 to $102 a share.

Continued: Narrowing it down

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