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How to Identify Value Traps in Stock Investing?

I keep writing blog posts about undervalued stocks. My posts stress a lot about how important it is for investors to buy undervalued stocks.

But in the process of focusing on undervalued stocks, sometimes people fall in the value trap.

It is an important point to note that any stock is not worth a buy simply because its price has fallen considerably.

For sure, this is one good indicator of a potential value stock. But looking only at price movements is wrong. One must never look only at price trends to judge if a stock is worth a buy.

So, a stock doesn’t automatically become attractive simple because its price has fallen?

Yes it is true. It is very important for investors to also check the fundamentals of stocks. Stock fundamentals are mainly driven by its ‘future’ potential business. What to look into stock figures to judge its future potential business?

1) Net worth,
2) Profits &
3) Sales.

Would you like to buy stocks of a company which is not doing good business since last 5 years?

Stocks of such companies generally trade at low price levels. Indicators of such stocks often misleads novice investors.

Stocks of such companies trade at such low price levels that it looks like they are value stocks. But actually, they are value traps.

To quickly judge a stock, we screen stocks based on their price earning (P/E) ratio & price to book value (P/B) ratio etc. All stocks which trade at low P/E and P/B ratios are good stocks to buy?

Not necessarily, these may also be value traps.

It is important to understand why price these stocks are trading at such low levels. Price fall may be triggered by weak business fundamentals of these stocks.

When price falls due to weak fundamentals, such stocks becomes potential value traps. We must guard ourselves completely from stocks of such companies.

Price fall may also happen when stocks of good companies get ignored by buyers. Such stocks are very desirable. But in stock market such stocks are cannot be easily found.

how to identify value traps in stock investing

Which stocks are good for buying?

Buy stocks of companies whose business fundamentals are strong and its market price trade at discount to its fair value.

Lets see an example for better understanding.
 – Company X has P/E ratio of 10, P/B ratio of 1.5 and dividend yield of 4%.
 – Company Y has P/E ratio of 15, P/B ratio of 1.8 and dividend yield of 2.5%.

Stock of which company, X or Y is more inviting for investment?

For sure Company X look more attractive than Company Y. But this conclusion may not be correct.

Based on only these 3 ratios, stocks cannot be judged completely. The information is not enough for full analysis.

Lets try to analyze more by comparing our stocks X & Y with BSE SENSEX. At present levels of Sensex (27,870), its P/E ratio is 21.09, P/B ratio is 2.84 and dividend yield of 1.41. Comparing X & Y with Sensex, X still looks more attractive than Y. But is this the right judgement?

The method is right, but the only problem is, this analysis is still incomplete.

A complete analysis always include future predictions. Sales & profit forecast must be included to evaluate stocks. The data that is available with us about company X & Y are past data’s. We need some future data as well.

We will recalculate PE, PB & Dividend Yield based on future forecasts.

how to identify value traps in stock investing

Description Y2016 (Present) Y2017 Y2018 Average
Company X
EPS (E) E1 0.8E1 0.7E1 0.83E1
Book Value / Share (B) B1 0.9B1 0.8B1 0.90B1
Dividend / Share (D) D1 0.6D1 0.5D1 0.70D1
Company Y
EPS (E) E2 1.2E2 1.4E2 1.2E2
Book Value / Share (B) B2 1.1B2 1.2B2 1.1B2
Dividend / Share (C) D2 1.25D2 1.28D2 1.17D2

Bases on these future data’s, following stock data can be comprehended about company X & Y

Company X (Based on future 2 years values):
– P/E ratio of 12.87 (Current P/E=10 dividend by 0.83)
– P/B ratio of 1.66 & (Current P/B=1.5 dividend by 0.9)
– Dividend Yield of 2.8%. (Current Div Yield of 4% multiplied by 0.7)

Company Y (Based on future 2 years values):
– P/E ratio of 12.5 (Current P/E=15 dividend by 1.2)
– P/B ratio of 1.63 & (Current P/B=1.8 dividend by 1.1)
– Dividend Yield of 2.9%. (Current Div Yield of 2.5% multiplied by 1.17)

So here you can see that, when we were looking only at current valves, Company X was looking more attractive. But when we looked 2 years ahead, the same result got reversed. Company Y, considering is good future prospects, started looking more attractive.

Conclusion

It is always worth seeing a stock which is trading at too low a ratio levels with skepticism. Low price may also mean that there is something wrong with companies fundamentals. Companies which are trading at high price levels must be doing something right. But these are only guess works. It is better to do fundamental analysis of stocks before arriving at a buy or sell decision. In order not to fall into value traps, it is advisable to self analysis of stocks before buying one.



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Disclaimer: All blog posts of getmoneyrich.com are for information only. No blog posts should be considered as an investment advice or as a recommendation. The user must self-analyze all securities before investing in one.

About the Author

Mani
I am a Blogger with a passion for investment education. I started blogging in 2007-08. Blogging didn’t happened to me as a coincidence, it was a conscious decision. The idea with which I started blogging still stands true. In my starting days my finances remained tight. I was reading heavily about how to manage finance. One day I got hold of a book which my father gifted me in 2003. It was stacked below my graduation books. It was a small-thin book with its cover named "Rich Dad Poor Dad".....more

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