Best Buy: Stick to the electronics, pass on the stock

Q: I'm trying to decide whether or not to buy Best Buy bby. What do you think?

A: When the economy was roaring a few years ago, it wasn't uncommon to see long lines of people waiting to buy electronic gadgets in Best Buy stores.

The flat-screen TV was finally priced at a level that made it obtainable by many households. New digital music players were revolutionizing music and required consumers to upgrade their setups. And new video game consoles hit the market and were often accompanied by shoppers lining up outside their Best Buy store. Best Buy also got a boost from the continued struggles of its once chief rival Circuit City.

Now that the economy is slowing, business is likely to get more difficult for Best Buy. Making things even trickier, Best Buy must take on online competitors that almost always have lower prices. These factors combined may be a reason why the Best Buy's stock has fallen more than 13% this year.

Is this stock sell-off your green light to buy Best Buy? To find out, we'll put the stock through the four steps we consider when evaluating individual investments:

Step 1: Risk vs. reward. When you take a risk on a stock, you want to make sure you're properly rewarded. Downloading Best Buy's trading history back to 1985, and including the recent dividend yield of 1.1%, we see the company generated an average annual compound rate of return of 24.6%. That is a healthy return if you consider the S&P 500 has returned more than 10% annualized over the same time period, says IFA.com.

But to beat the S&P 500, you accepted sky-high risk — standard deviation — of 91 percentage points. That's 514% greater than S&P 500's risk during the same period. So to get a 146% higher return you accepted 514% higher risk. Not a great deal.

Step 2: Measure the stock's discounted cash flow. Some investors decide if a stock is pricey by comparing its current price to the present value of its expected cash flows. It's a complicated analysis made simple with a system from NewConstructs. When we run Best Buy's stock, we find it's rated "neutral." In other words, the current stock price is equal to what the company is expected to generate in cash over it's lifetime. Using this analysis, it would appear Best Buy's stock is neither cheap nor overly expensive.

Transparent Value, a website that figures out what business milestones a company must meet to justify its stock price, gives us more information. It says Best Buy has a 70.25% chance of hitting the financial targets it needs to justify its current stock price. The scarier way to think of that is there's a nearly 30% chance the company will miss the financial goals it needs to hit. Not great odds.

Step 3: Compare the stock's current valuation to its historical range. BetterInvesting's Stock Selection Guide can help. If the company can increase earnings 15% a year the next five years, as analysts expect, that would put the stock in the "buy" range. That's a green light for investors who believe the price-to-earnings ratio will return to historical norms.

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