Fortunately, you'll also notice that all market pullbacks eventually give way to powerful recoveries. Like a rubber band stretched too far, sellers have gone overboard and pushed equity prices through the floor, meaning they will likely spring back with equal force once economic conditions improve.

    But in the meantime, long-term investors should be cheering this irrational dumping of quality stocks. Because if you total up the cost to purchase every single share of every U.S. company, you would find that the price tag has been slashed by more than $8 trillion so far this year -- now that's what I call rolling back prices.

    If you walked into a retail outlet like Best Buy or Target and found row after row of quality merchandise marked down -40% or more, you would probably load up the shopping cart. However, counterintuitive though it may seem, investors aren't wired quite the same way and tend to fear massive stock declines rather than embrace them for what they really are -- golden windows of opportunity.

    Case in point, shares of Best Buy (NYSE: BBY) itself have just been dumped in the 50%-off bucket. But instead of piling in, investors are still running away -- even though the electronics king continues to gobble up market share and has promising growth opportunities overseas. In short, the company hasn't fundamentally changed much over the past year -- but a $10,000 investment will now get you 400 shares instead of 200.

    This remarkable pullback has afforded far-sighted investors the chance to look past temporary macroeconomic weakness and scoop up Best Buy and many other iconic and powerful American firms at drastically marked-down prices. The real challenge, of course, is finding the right companies.

    To aid in your search, the remainder of today's report is dedicated to three proven value investing strategies that can position your portfolio for maximum returns once this economic fog has lifted.

     Strategy #1 -- Stocks Trading Below Historical Norms

    As a valuation tool, Price/Earnings (P/E) ratios can be fairly blunt instruments. However, they do give us a pretty good idea of what investors are typically willing to pay for a company relative to every dollar of earnings it generates. And they can also serve as a broad indicator of whether a stock, a specific sector, or even an entire country is undervalued or overvalued.

    You might think that with prices plunging, P/E's would fall through the floor in a bear market. But that isn't always the case, because earnings are generally sliding just as fast as share prices -- if not faster. So it's not uncommon in a period of market weakness for P/Es to stay level, or even possibly tick higher.

    According to Reuters, the average stock in the S&P 500 is currently priced at 18 times trailing earnings -- directly in the middle of a five-year range that has dipped as low as 8 and spiked as high as 28. But keep in mind, this is simply a market average; some stocks remain pricey, but many others have been driven to rock-bottom levels. In fact, I count over 800 stocks in the U.S. alone trading below than 5 times earnings -- less than one-third of the broader market norm.

    Of course, some industries (like banks) traditionally trade at relatively low earnings multiples even in good times, so they might not be as cheap as they seem at first glance. Therefore, it's usually a good idea to compare a stock's P/E to that of its peer group as well as its own historical average. If a quality company with an undamaged outlook typically commands 20 times earnings but is suddenly getting only 10, then you may have a prospect.

    To demonstrate, let's take a look at cruise line operator Carnival (NYSE: CCL). In 2007, the firm reported total earnings of $2.95 per share and its stock closed the year at $43.14, for a P/E ratio of 14.6. But with higher fuel prices and a slowing economy acting as headwinds, the company is only on track to earn $2.65 per share this year. Assuming the stock maintained the same multiple of 14.6, then we could reasonably expect the shares to slide to $38.69.

    However, not only are profits down, but investors are also unwilling to pay as much per dollar of earnings as they were before (a double whammy known as margin compression). So while earnings have only dropped -10%, the shares have retreated more than -45%, falling all the way back to $22. Some basic math shows the current P/E at just 8.4 -- less than half the lofty average multiple of 20.4 that it has garnered over the past five years.

    To me, this suggests that the punishment hasn't fit the crime. Once sentiment improves and valuations return to normal, the current earnings base of $2.65 could support a share price above $54 ($2.65 * 20.4). And clearly, earnings aren't likely to remain flat -- analysts are forecasting healthy double-digit growth over the next five years.

    In short, those who take advantage of this overdone pullback and pick up CCL at this level could ultimately see triple-digit gains. In the table below, you'll find several other prime examples of attractive companies that have been unfairly punished and now look extremely underpriced.

     Strategy #2 -- Growth at a Reasonable Price (GARP)

    As you can see, P/E ratios are useful in identifying severely underpriced stocks that may be poised for a dramatic recovery. However, like any metric, they don't tell the whole story and shouldn't be used in isolation. After all, they say nothing about a company's future growth potential. Two stocks trading at identical P/E ratios of 12.0 might seem to be equally valued. But what if the first company was expected to deliver earnings growth of +10% annually and the second was projected to boost its bottom line by +20% per year?

    All things being equal, you would clearly prefer the second company.

    It stands to reason that a company's future earnings are actually a key component of its value. We all like to be part owners of companies that are churning out wider and deeper profit streams each year. And because faster-growing companies are more valuable to their owners, they can trade at richer multiples and still be considered good buys.

    The trick lies in knowing how to level the playing field for companies moving at different speeds.

    Let's return to the example above, only now we'll assume that the second stock is trading at 16 times earnings, versus just 12 for the first. Is it more expensive? Not on a Price/Earnings/Growth (PEG) basis. In fact, the first stock is trading at a PEG of 1.2 (12/10) -- a 20% premium to its growth rate. By contrast, the second carries a much more attractive PEG of 0.8 (16/20) -- a 20% discount.

    All of this is to say that some companies that may seem expensive on the surface are actually undervalued once their future growth potential is factored in. So investors that automatically dismiss stocks with seemingly high P/Es could be missing out on some of the market's most extraordinary opportunities.

    Just look at Apple (Nasdaq: AAPL). The shares have traded at an average multiple of 44 over the past five years, enough to scare some investors away. Yet, considering earnings have advanced +124% annually over the same time frame, the stock has still been sharply undervalued. As a result, shareholders have enjoyed gains in excess of +750% since 2003.

    This growth at a reasonable price (GARP) approach was pioneered by legendary mutual fund manager Peter Lynch. In his best-selling book Beating the Street, Lynch observed that "any time you can find a +25% grower selling for 20 times earnings, it's a buy. If the price dropped any further, I'd back up the truck."

    Lynch was handed the reins to the Fidelity Magellan Fund in 1977 when the portfolio was worth just $20 million. By the time he retired in 1990, some individual holdings alone were worth over $100 million and the portfolio had ballooned to more than $14 billion. Along the way, shareholders racked up annualized returns of +29% and were rewarded with a staggering +2,700% cumulative gain.

    Today, you can follow a similar approach by scouting for stocks with attractive PEG ratios. As a rule of thumb, readings below 1.0 are usually indicative of value -- but in this market, you may want to tighten your standards.

    In the table below, I have listed a handful of quality companies that are highly compelling on a PEG basis.

     Strategy #3 -- Stocks Trading at Discounts to Fair Value

    While the two strategies above can indeed help you uncover undervalued stocks with huge upside potential, there is still a far more precise analytical tool available.

    If you find a stock with a P/E of 8 and a price of $25, it may or may not be a good buy. There are still many unanswered questions that must be addressed: Is the company gaining or losing market share? Are profit margins expanding or contracting? How leveraged is the firm's balance sheet? Where are earnings headed over the next few years? Does the industry have any barriers to entry?

    But if we can incorporate these and many other factors to determine that the same $25 stock has an actual fair value of $50, then much of the uncertainty has been removed.

    Fortunately, there is comprehensive tool that goes light years beyond P/E in accurately calculating what a stock is really worth. This technique, known as discounted cash flow analysis (DCF), is what many of the world's sharpest value investors rely on almost exclusively.

    Regardless of the type, the value of any financial asset is primarily driven by three factors:

    -- The cash flows that it generates for its owners.
    -- The growth and timing of those cash flows.
    -- The capital necessary to earn them.

    That cash might come in the form of semi-annual interest payments for a bond, or monthly rental income for a piece of real estate. For a stock, we are primarily interested in the firm's free cash flow (FCF).

    Essentially, FCF is the money left over after all the bills have been paid. It can be used to repurchase shares, pay dividends, reduce debt, make acquisitions, or simply plow back in the business -- and it's what truly drives stock prices. In its most basic form, DCF analysis projects a firm's future cash flows and then discounts them back to the present to determine what they're worth in today's dollars. Divide that total by the number of shares outstanding, and you've got fair value.

    Actually, that is an overly simplified explanation. The actual process involves the income statement, the balance sheet, and the statement of cash flows and uses a host of forecasts regarding things like capital expenditures and weighted average cost of capital (WACC) to arrive at a stock's fair value. The actual calculation looks like this:

    DCF = CF1/((1+r)^1) + CF2/((1+r)^2) + CF3/((1+r)^3)...+ CFn/((1+r)^n)

    Of course, if you're not mathematically inclined or would simply rather have someone else crunch all the numbers, my Half-Priced Stocks newsletter uses DCF exclusively to dig up promising stocks that have been underpriced by myopic investors.

    Under ordinary market conditions, stocks are (for the most part) priced fairly accurately. For a company to plunge 50% or more below what it's really worth, it often takes a calamitous event (costly product recall, adverse FDA ruling, loss of a major customer, etc.) and a knee-jerk reaction on Wall Street.

    But the beauty of this downturn is that all stocks have been pummeled indiscriminately -- the good with the bad. In fact, there are more than 3,000 U.S.-listed stocks that have lost -75% of their value or more over the past year. With rational behavior giving way to panic, we're seeing prices that are almost never available during ordinary circumstances. So now, you don't have to dig near as deep to uncover that $20 stock trading for just $10, and you don't have to settle for troubled companies facing big obstacles.

    Consider Dell (Nasdaq: DELL), a company whose shares have cratered while its fair value has remained largely unchanged. As the nation's largest PC maker, the firm ships about 140,000 computer systems around the world each day -- more than 1 every second. Those sales have lead to a mountain of $2.8 billion in free cash flow over the past year.

    But the market doesn't see any of that right now, and has pushed the stock down around $12.00 per share. But even assuming a conservative +10% growth rate (analysts are expecting +14%), the firm's current assets and future cash flows yield a fair value of $31 per share.

    Eventually, investors will again realize that Dell is a valuable business that they would like to be a part of -- and a return to just half of its fair value would see gains of +25% from current levels. But this is hardly an isolated example, and below I have provided several more examples of deeply discounted stocks with room to climb.

    There are two ways to look at this tumultuous year-long selloff in the market: it's either a frightening nightmare or a golden window of opportunity.

    Yes, most of the ticker symbols you follow (or own) are down alarmingly from their peaks. But as Warren Buffett astutely reminds us, successful investors don't rent stocks -- they own businesses. And right now, many of the world's most powerful companies can be purchased at levels that haven't been seen in decades.

    So thank the market for its manic-depressive mood swings and take advantage of this clearance sale while you still can.

Nathan Slaughter Editor Half-Priced Stocks, The ETF Authority

To receive in-depth guidance on today's leading value opportunities, plus educational guidance, please subscribe to Nathan Slaughter's premium value investing newsletter -- Half-Priced Stocks

   

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