What “Catch a Falling Knife” Can Mean to a Value Investor

By Stock Research Pro • October 28th, 2009

“Catch a falling knife” is a phrase used by stock investors to describe a stock that has decreased sharply in value in a short amount of time. While many new investors see falling stock prices as an opportunity for purchase, it can be a risky strategy. Although a stock whose price is falling can rebound, there is a danger that the stock will continue to decrease and may even become worthless if the company goes bankrupt. In fact, when a stock falls very dramatically in a short period of time, it is often as a prelude to an awful earnings report or a bankruptcy filing. Still, many value investors see opportunity in falling knives.

Falling Knife and Value Investing

Under a value investing strategy, investors look for stock candidates that have wrongly fallen out of favor with the market. In a real value opportunity, the company continues to demonstrate strong fundamentals, sound management, and growth prospects.

Stock screeners are powerful tools to differentiate real value investing opportunities from falling knives. In building a screen for value stocks, the criteria might include:

Price/ Earnings Ratio less than 20 and less than industry peers: The price/earnings or “P/E” ratio compares the current share price with the company’s earnings per share. The P/E ratio provides an indication as to how much investors are spending on for each unit of company earnings.

Price/ Book Ratio less than 3.0 and less than industry peers: The price/book or “P/B” ratio compares the book value of a company to its market value to help determine the relative value of the stock.

Projected Earnings-per-Share Growth greater than 10%: Earnings-per-share of “EPS” represents the portion of company earnings allocated to each share of common stock. Forecasted growth in EPS is a positive sign for any company.

Positive Return-on-Equity: Return-on-Equity or “ROE” is a measure of a company’s profitability with regard to the money invested by shareholders. A high ROE indicates that the company can fund expansion opportunities without requiring more shareholder capital.

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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