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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; stocks are not worth a buy simply because its price has fallen cpnsiderably. For sure, this is one good indicator of a potential value stock. But looking only at price movements is wrong. The point is, do not just look at price to judge if a stock is worth a buy.

A stock becomes attractive when its price falls? This is only partially true. It is very important for investors to also check the fundamentals of stocks. Stock fundamentals are mainly driven by its ‘future’ net wroth, profits and 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 attractive price levels, or we can say that the indicators misleads. Stocks of such companies trade at such low price levels that it looks like value stocks. But actually, they are value traps.

In stock analysis we screen stocks based on price earning ratios, price to book value ratios 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 of certain stocks fall. Price fall may be triggered by weak business fundamentals. Price fall may also happen when stocks of good companies get ignored by buyers. When price falls due to weak fundamentals, such stocks becomes potential value traps. We must guard ourselves completely from stocks of such companies.

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 analyzed 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 righ way to analyze stocks?

The method is right, but the only problem is, this analysis is 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 Y2017 Y2018 Average
Company X
EPS E1 0.8E1 0.7E1 0.83E1
Book Value / Share B1 0.9B1 0.8B1 0.90B1
Dividend / Share D1 0.6D1 0.5D1 0.70D1
Company Y
EPS E2 1.2E2 1.4E2 1.2E2
Book Value / Share B2 1.1B2 1.2B2 1.1B2
Dividend / Share 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
– P/B ratio of 1.66 &
– Dividend Yield of 2.8%.

Company Y (Based on future 2 years values):
– P/E ratio of 12.5
– P/B ratio of 1.63 &
– Dividend Yield of 2.9%.

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.

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