When stocks are beaten down, many investors are tempted to bottom fish for bargains.

There is nothing wrong with this. There are major profits to be made in bear markets.

But Lynn Carpenter in Investor’s Daily Edge cautions investors against confusing a low stock price with a bargain: “Potential, not price, is the metric to follow when you’re tempted to bottom fish.”

That’s why insurer American International Group (NYSE:AIG) is a potential bargain and Ford Motor Company (NYSE:F) is not…

The trick is finding beaten-down stocks that are showing the potential for company profits. Unless the company has hopes of making money or at least paying you a dividend, its stock is no bargain at any price.

“It can’t fall any farther.” “It’s too important to fail”… these are follies. Big companies fail all the time. Just Google “Barings” if you want a spectacular example of a venerable company that went from blue chip to cow chip in record time. 

If Ford doesn’t sell cars, Toyota will. X number of cars are going to be bought next year, and even the old folks who used to only buy American are driving Hondas, Toyotas and Nissan’s these days. If AIG doesn’t sell you property insurance, ING, State Farm or AXA will. Where there are buyers lined up, competitors will come along and do business. This is how capitalism works.

INTERNAL ENDORSEMENT Winners Cherry Pick! Losers Bottom Feed Thousands of stocks have just fallen 40% or more… most will continue to tumble… but you should still overpower the markets. Because a select few stocks are now set to roar back for outstanding near-term gains. It’s time to party like it’s 2002 You don’t want to miss out… because, today, you can jump into any one of seven companies at what should be their once-in-a-lifetime lows… each is poised to take you to new highs. Grab this low-hanging fruit here.

But with stocks like AIG and Ford so far down from their highs, a lot of investors are forgetting the reality of the business behind the stock. They see a cheap share that could make them thousands of dollars climbing back from today’s lows to reach yesterday’s highs again. It’s half of a right idea. What’s to lose?

A lot. Maybe everything. If the worst happens, Ford could follow Studebaker. AIG could go the way of American Mutual. It’s good to get a cheap stock, but it’s not a great idea in itself. A great move is getting a terrific company during a bad patch or one that others have underestimated and priced at a discount to its true potential. The key is in knowing the potential. It has zero relationship to a company’s historical share price.

Potential, not price, is the metric to follow when you’re tempted to bottom fish. Let’s walk through two contrasting cases.

This week, AIG hit an 18-year low. Analysts expect the insurer to earn $4.94 per share next year. Insurance companies tend to command low P/E ratios, between 12 and 17 for property and casualty insurers. Go to the low end. Consider that analysts are too optimistic and figure on $3.40 per share in earnings, a 25% discount.

Then take the very lowest historical P/E of 12. That makes AIG worth a theoretical $40.80. At today’s price of $19, it does represent a probable value… if the earnings estimates are even close. The company also has good long-term earnings potential if its derivatives write-downs don’t kill it first. More investigation is needed, but this is certainly worth checking.

Now look at Ford. Analysts expect -$1.81 in earnings from Ford this year and -.78 next year. We’ll follow the same procedure – say it’s 25% worse. That’s -$.98 in earnings for 2009. There is no P/E because there are no positive earnings. There’s no dividend anymore, either. What about price to book value, a deal if it’s less than 1.0, right? A decent level might even go to 1.2 times book value per share like Daimler or Honda. The problem is that Ford’s so far in debt, its liabilities outweigh its assets and its book value is negative, too.

No prospects of earnings foreseeable, no dividend, outrageous debt, book value under water… what would an investor hope for in Ford? Even Lee Iacocca isn’t that brave. Ford’s stock may be just north of $4, but it’s no bargain. If you want to take a bet on that, you are far braver than I am. You have to believe in magic. Ford is years away from financial health, if it ever gets there. As for a government bailout, the only one I see is one that protects the workers in its shattered pension plans.

Somebody may make a killing buying Ford today and reflecting on his coup 10 years from now, but it’s a long shot.

Source: The Secret to Bottom Fishing Distressed Stocks