Separating Value Stocks from Value Traps
A Value Trap stock is a stock that has had a dramatic price drop and may be falsely perceived to be a value stock. While a stock that is trading a low price/earnings (P/E) ratio or some other low valuation measure might be at that price level for good reason, investors may be drawn to that stock in the hopes of acquiring it at a bargain price and enjoying the price appreciation as the market corrects its mistake. The challenge for the value investor is in determining whether the company’s falling out of favor is a temporary setback or appropriate pricing for a stock that is not likely to recover.
The Definition of a Value Stock
A value stock is a stock that is currently undervalued by the market. Value stocks typically trade at price levels that are too low, given the company’s strong fundamentals and prospects for future growth. Value investors believe that eventually, the share price will rise back to a level that reflects the true underlying value of the business. Common characteristics of value stocks include:
• Low price/book ratio
• Low price/earnings ratio
• High Dividend Yield
While stocks that offer one or all of these characteristics are promising, they need to be examined in more detail before deeming them a true value play.
Value Stock or Value Trap?
Stocks that are perceived as “bargains” often show strong balance sheets and fundamentals, but may be operating in an industry in decline. On the other hand, the company may be operating in a growth industry, but demonstrating weak fundamentals. Some of the details value investors might look at in identifying real value stocks might include:
Debt-Load: The debt/equity ratio is used to measure the solvency of the company. The ratio compares what the company owns to what it owes to determine how leveraged the company is- that is, its ability to borrow money and repay those loans. A high debt/equity ratio can be a significant warning sign for investors.
Free Cash Flow (FCF): While earnings can be manipulated through creative accounting practices, cash cannot. If the company’s level of free cash flow flow is not stable and growing, its management is losing its available resources for architecting a turnaround.
Insider Actions: The behavior of company insiders can be one of the best indications of what is truly going on in the company. If insiders are not buying up the stock at cheap prices, investors are left to wonder what these insiders know.
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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.
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