Aug. 17 (Bloomberg) -- After more than three years of torment, homebuilding stocks have been looking strong. In July they rose about 25 percent, and so far in August they have chugged ahead another 9 percent.

The latest boost to these volatile stocks came Aug. 12, when Toll Brothers Inc., the third largest U.S. luxury home builder, shocked analysts by reporting an increase in orders. Robert Toll, chief executive officer of the Horsham, Pennsylvania, company, said he believes the housing industry reached bottom two or three months ago.

On that news, Toll Brothers shares jumped 14 percent, while competitors rose about 3 percent.

Is it time to buy the homebuilders, which were market darlings in 2003 through 2005?

The bullish case begins with the fact that the stocks had fallen so far. As a group, they plunged an astonishing 90 percent from July 20, 2005, through Nov. 21, 2008.

That’s comparable to the slide in Internet stocks in 2000- 2002. By some measures, the homebuilders had it worse.

By the same token, homebuilding stocks are cheap. The question is whether they deserve to be.

You can’t easily use what is normally my favorite tool, the price-earnings ratio, because there are no earnings at the moment. For example, DR Horton Inc. of Fort Worth, Texas, the largest U.S. homebuilder by market value, had a net loss of $2.6 billion last year on sales of $6.6 billion.

Malt Shop P/E

You can, however, compute what I sometimes call the malt shop P/E ratio. Start with the stock price. Divide it by the third-best annual earnings achieved by the company in the past 10 years. This gives you a measure of how the stock is selling compared with normalized earnings.

I calculated the malt shop P/E for DR Horton, Toll Brothers and seven other homebuilders with a market value of more than $1 billion. They are NVR Inc. of Reston, Virginia, Pulte Homes Inc. of Bloomfield Hills, Michigan, Lennar Corp. of Miami, MDC Holdings Inc. of Denver, KB Home of Los Angeles, Centex Corp. of Dallas, and Ryland Group Inc. of Calabasas, California.

The malt shop P/E is two for Centex and Lennar, three for KB Home, Pulte and Ryland, five for MDC and DR Horton, and eight for NVR and Toll Brothers. To me, those are attractive ratios.

More traditional measures, such as price-to-book and price- to-sales ratios, also look good for most of these stocks. (Book value is corporate net worth per share.)

Industry Fundamentals

What’s more, the industry’s fundamentals have turned up. In June new homes sold at a seasonally adjusted rate of 384,000 a year. While that is a far cry from the pace of more than 1 million a year during much of 2003 through mid-2006, it was an improvement from the January 2009 bottom of 329,000.

The average selling price for a new house, which had fallen below $250,000 in January, has rebounded to $276,000. For much of 2006 and 2007, it was above $300,000. (The high was $329,400 in March 2007.)

Now, what about the bear case? On the negative side, the most potent argument is that the U.S. has more houses than it needs. From 2003 through 2006 the industry enthusiastically cranked out homes, some of them purchased for speculation and not to live in.

An inventory of 3.8 million homes now hangs over the market. In addition, foreclosures on homes whose owners can’t make their mortgage payments are running high. The June figure of 336,173 was the second highest, surpassed only by April’s 342,038.

Making Sense

Weighing the bullish and bearish arguments, I believe that it makes sense to begin buying homebuilding stocks. However, the eternal curse of value investors is to be early.

To protect against that tendency, I suggest establishing a toehold position now, and adding to it at three-month intervals. For example, if you want to end up with a 5 percent position in homebuilders, you might buy a 1 or 2 percent position now, and add to it in November and again in February 2010.

Which homebuilders are attractive? To answer that question, I would start by looking at the companies’ debt levels. Many of the homebuilders’ balance sheets have been shredded by three adverse years.

The ones that are financially strong have a better chance of lasting through the hard times that still prevail.

In buying stocks, my normal debt limit is 100 percent of equity. Of the eight biggest homebuilders, only two now meet that standard.

They are NVR (debt 15 percent of equity) and Toll Brothers (80 percent). Lennar and MDC Holdings are near misses, with a debt-to-equity ratio of 107 percent and 103 percent, respectively.

Lennar, Toll Brothers

My favorite is Lennar, which I like for a couple of reasons. First, I think investors are punishing the company because of its Florida location.

Goodness knows, the Florida real estate market, Lennar’s home turf, is more tattered than most. But Lennar builds homes in 17 states, including New York, California, Arizona and Texas.

I also like Lennar because it (alone in this eight-stock group) sells for less than book value.

Next best I like Toll Brothers. A couple of its board members have been buying shares this year. Robert Toll, the CEO, has sold some shares but remains a big holder.

Disclosure note: I currently have no long or short positions in the stocks discussed in this column.

(John Dorfman, chairman of Thunderstorm Capital in Boston, is a columnist for Bloomberg News. The opinions expressed are his own. His firm or clients may own or trade securities discussed in this column.)

To contact the writer of this column: John Dorfman at jdorfman@thunderstormcapital.com.

Last Updated: August 16, 2009 21:00 EDT