Sometimes a stock which may look like a value stock due to a major drop in price, but which is not actually undervalued. Such stocks attract investors who are looking for a bargain because such stocks are comparatively cheaper than other stocks. The trap springs when investors buy stock of the company at low prices and the stock continues to drop further. This is known as “Value Traps”.
The stock price may have fallen due to its circumstances, and it may actually continue to fall. In order to avoid value traps, investors should study not only the stock price but also financial information about that company.
Signs of value traps:
1. A company is at top of operating cycle and still in problems
2. Management compensation structure is not changing even if the stock is declining
3. Business keeps losing market share, although the industry is doing well
4. The capital allocation process is not changing fast enough.
5. Management’s near-term goals are not achievable, and/or managers have failed at the majority of prior year goals.
6. The company has more financial leverage than it can sustain.
How to avoid value traps:
1.P/E to Growth ratio (PEG ratio):
PEG ratio can be calculated as PE divided by growth rate of the company. PEG ratio helps to find the actual growth of the company.
2.Estimate the future stock price:
Estimation of future stock price should not for neither very short period nor too long period. Estimation of future stock price should be done for 5 years. If the estimated price is lesser than today’s price or has very lesser returns, then there is no point to invest in such stocks.
3.Balance sheet safety:
For very small companies with debt, look at the interest coverage ratio as the representative for business health. The ratio of short-term receivables to payables is also an important factor to consider. Irrespective of the industry, consistency in this ratio indicates good management of working capital.
4.Have a time frame and stick to it:
Investing in stocks should not be your only source of income, because it is recommended that having less return is always better than having losses. Always think about the opportunity cost of capital. Progress for small companies can take longer time than expected.
5.Too much debt:
When a company becomes overly leveraged, then that situation is unhealthy for a company. If the revenue of company and stock price of the company have declined, the interest on its outstanding debt becomes a higher percentage of revenues and income. When this happens debt becomes difficult to manage.