How to Avoid Value Traps in Stocks
Stay clear of stocks that have dropped in price due to to exposed corporate fraud., Beware of an overly optimistic outlook from a company's management., Avoid companies with high debt or leverage., Avoid companies dealing in outdated products and...
Step-by-Step Guide
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Step 1: Stay clear of stocks that have dropped in price due to to exposed corporate fraud.
Some recent examples like Enron, WorldCom, and Tyco experienced a marked drop in prices that made them look like bargains after their scandals were exposed.
In the end, however, they found themselves on a relentless trajectory to zero, leaving shareholders with nothing.
Wherever fraud is involved, the figures in financial statements that are used to determine value are meaningless, and the company simply cannot be valued appropriately.
Moreover, once fraud is discovered, a company tends to have little or no value left that has not already been stolen by corrupt management.
Do not consider stocks of companies involved in corporate fraud. -
Step 2: Beware of an overly optimistic outlook from a company's management.
Any company that promises to deliver consistently increasing, double-digit earnings growth is unrealistic, and such promises, when they become undeliverable, may lead to fabrication of figures by management.
Warren Buffett bought huge stakes in Freddie Mac during the 1980s when the stock was truly cheap.
He liquidated his position for a $2.75 billion profit in the late 1990s after he saw signs that the overly optimistic goals of the company's management were unachievable., Debt is a double-edged sword.
In good times you can make a lot of money using leverage, and borrowing is easy.
In bad times you can lose money very fast, and the time when you need money the most is when creditors start calling you and demanding repayment.
For a good margin of safety to make sure a company is able to satisfy interest payments on its debt, look for companies with two-to-four times interest coverage (earnings before interest at least two-to-four times interest charges).
Upper limit applies to industrial issues, especially cyclical ones; lower limit applies to more stable incomes such as utilities.
A company with no debt is highly unlikely to go bankrupt, barring unforeseen misfortunes (such as a massive legal settlement against it) or an inability to sell its products for more than it costs to create those products (evidenced by negative net income on the income statement).
On the other hand, excessive leverage can destroy even a great company. , Blockbuster is a good example: who needs to go to a physical store to get videos or DVDs when they can be downloaded at home with the click of a mouse? Likewise, newspapers and physical bookstore businesses have been hurt by the expanding Internet.
Outdated products and services often signify that the lost revenues are probably lost forever and that a rebound in the stock price is unlikely. , Look at the profit margins (net earnings divided by revenue) of a company through a period of five to ten years.
Compare to profit margins of competitors in its industry.
If the profit margins are decreasing through the years, that usually signifies that the company is unable to pass increasing costs on to its customers because of the need to maintain competitive prices.
If a company is no longer competitive, it's better to avoid it despite the low valuations. , Because of high fees and regulation costs in the U.S., for example, many companies have relocated their businesses to other countries like China.
Most consumer goods are no longer made in the U.S.
Payday loans are another example.
Making $20 in fees for every $100 loaned out, payable in two or three weeks, is quite profitable.
However, government caps that put the maximum interest rate at 36 percent per annum cut profits significantly. , Dividend cuts usually mean the company has limited earnings to pay out.
The price correction following a dividend cut can be prolonged.
Don't buy until valuations are really compelling, as when significant price drops send the stock to 50 percent or less of its intrinsic value. , Analysts are generally quite lenient in their estimates and tend to revise their estimates downward before earnings are announced.
This allows companies to beat their estimates and look good.
Occasional missed earnings estimates with overreaction in the price is a solid reason to buy "on the dip," but a pattern of missed earnings estimates is foreboding. , Look at the company's income statements dating back at least five years (ten is better).
A consistently profitable company should have at least some earnings per share for each of the past five-to-ten years, preferably with an upward trend.
A company with consistent negative earnings for several years may be too expensive at any price. , Insiders are in the best position to know how much their company is really worth.
If the stock price is truly cheap, they will be buying the stock.
There is only one reason why insiders buy: they expect the stock to go up.
If you see a recent history of insider buying, it's a safe bet to follow suit.
On the other hand, if you see many insiders selling a stock you're considering, it may be an ominous sign, and you should probably keep your hands off. , One of the most important things to look for is that the company has current assets greater than current liabilities, to ensure that it can pay its bills in the short term.
A more stringent test is to calculate the quick net asset value by subtracting inventory (which may be liquid) and total current liabilities from current assets.
Alternatively, determine the quick current ratio by dividing total current assets (less inventory) by total current liabilities.
Make sure the ratio is greater than one.
Another measurement of financial health is the debt-to-equity ratio, obtained by dividing total liabilities by the sum of shareholders' equity and capital surplus.
The debt-to-equity ratio should be less than one; the lower, the better. -
Step 3: Avoid companies with high debt or leverage.
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Step 4: Avoid companies dealing in outdated products and services.
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Step 5: Be careful of companies facing increasingly stiff competition.
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Step 6: Be wary of companies in highly regulated industries.
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Step 7: Be careful when investing in stocks that have dropped due to a dividend cut
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Step 8: especially when the company does not expect to resume dividends any time soon.
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Step 9: Watch out for missed earnings estimates.
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Step 10: Invest in profitable enterprises only.
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Step 11: Look for insider buying.
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Step 12: Check the balance sheet to make sure the company is healthy.
Detailed Guide
Some recent examples like Enron, WorldCom, and Tyco experienced a marked drop in prices that made them look like bargains after their scandals were exposed.
In the end, however, they found themselves on a relentless trajectory to zero, leaving shareholders with nothing.
Wherever fraud is involved, the figures in financial statements that are used to determine value are meaningless, and the company simply cannot be valued appropriately.
Moreover, once fraud is discovered, a company tends to have little or no value left that has not already been stolen by corrupt management.
Do not consider stocks of companies involved in corporate fraud.
Any company that promises to deliver consistently increasing, double-digit earnings growth is unrealistic, and such promises, when they become undeliverable, may lead to fabrication of figures by management.
Warren Buffett bought huge stakes in Freddie Mac during the 1980s when the stock was truly cheap.
He liquidated his position for a $2.75 billion profit in the late 1990s after he saw signs that the overly optimistic goals of the company's management were unachievable., Debt is a double-edged sword.
In good times you can make a lot of money using leverage, and borrowing is easy.
In bad times you can lose money very fast, and the time when you need money the most is when creditors start calling you and demanding repayment.
For a good margin of safety to make sure a company is able to satisfy interest payments on its debt, look for companies with two-to-four times interest coverage (earnings before interest at least two-to-four times interest charges).
Upper limit applies to industrial issues, especially cyclical ones; lower limit applies to more stable incomes such as utilities.
A company with no debt is highly unlikely to go bankrupt, barring unforeseen misfortunes (such as a massive legal settlement against it) or an inability to sell its products for more than it costs to create those products (evidenced by negative net income on the income statement).
On the other hand, excessive leverage can destroy even a great company. , Blockbuster is a good example: who needs to go to a physical store to get videos or DVDs when they can be downloaded at home with the click of a mouse? Likewise, newspapers and physical bookstore businesses have been hurt by the expanding Internet.
Outdated products and services often signify that the lost revenues are probably lost forever and that a rebound in the stock price is unlikely. , Look at the profit margins (net earnings divided by revenue) of a company through a period of five to ten years.
Compare to profit margins of competitors in its industry.
If the profit margins are decreasing through the years, that usually signifies that the company is unable to pass increasing costs on to its customers because of the need to maintain competitive prices.
If a company is no longer competitive, it's better to avoid it despite the low valuations. , Because of high fees and regulation costs in the U.S., for example, many companies have relocated their businesses to other countries like China.
Most consumer goods are no longer made in the U.S.
Payday loans are another example.
Making $20 in fees for every $100 loaned out, payable in two or three weeks, is quite profitable.
However, government caps that put the maximum interest rate at 36 percent per annum cut profits significantly. , Dividend cuts usually mean the company has limited earnings to pay out.
The price correction following a dividend cut can be prolonged.
Don't buy until valuations are really compelling, as when significant price drops send the stock to 50 percent or less of its intrinsic value. , Analysts are generally quite lenient in their estimates and tend to revise their estimates downward before earnings are announced.
This allows companies to beat their estimates and look good.
Occasional missed earnings estimates with overreaction in the price is a solid reason to buy "on the dip," but a pattern of missed earnings estimates is foreboding. , Look at the company's income statements dating back at least five years (ten is better).
A consistently profitable company should have at least some earnings per share for each of the past five-to-ten years, preferably with an upward trend.
A company with consistent negative earnings for several years may be too expensive at any price. , Insiders are in the best position to know how much their company is really worth.
If the stock price is truly cheap, they will be buying the stock.
There is only one reason why insiders buy: they expect the stock to go up.
If you see a recent history of insider buying, it's a safe bet to follow suit.
On the other hand, if you see many insiders selling a stock you're considering, it may be an ominous sign, and you should probably keep your hands off. , One of the most important things to look for is that the company has current assets greater than current liabilities, to ensure that it can pay its bills in the short term.
A more stringent test is to calculate the quick net asset value by subtracting inventory (which may be liquid) and total current liabilities from current assets.
Alternatively, determine the quick current ratio by dividing total current assets (less inventory) by total current liabilities.
Make sure the ratio is greater than one.
Another measurement of financial health is the debt-to-equity ratio, obtained by dividing total liabilities by the sum of shareholders' equity and capital surplus.
The debt-to-equity ratio should be less than one; the lower, the better.
About the Author
Lori Gray
Dedicated to helping readers learn new skills in lifestyle and beyond.
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