7 Factors to Consider Whether Your Investment is a Value Trap
1. Earnings and Cash Flow
If
a stock’s price is very cheap compared to past earnings this is a
warning sign. Past earnings have little effect on the future price of an
investment. The markets are looking forward to discount future cash
flows. If an investment has fallen to the point where it is absurdly
cheap compared to past earnings, that is a clue something is deeply
wrong.
2. Business Plan
Beware
of a business plan that is not understandable or is unprofitable. If a
company is unable to make profits or has a plan that is complicated and
hard to explain – avoid it.
Bypass
companies whose business plan has been outdated by new technologies.
If a product or service is outdated it doesn’t really matter how many
other good attributes the company has; it will most likely fail.
Technological obsolescence is a common misfortune of many business
plans.
3. Management
Poor
management can sink almost any company. If management is selling stock,
giving guidance that is untrustworthy, or cutting the dividend; beware.
These would be signs of a possible value trap.
Look
for management that owns their company’s stock; insider buying is a
positive sign. Quality management will give trustworthy guidance and
demonstrate they have the knowledge to successfully guide the company.
4. Accounting
Producing
complicated or fraudulent company accounting reports often means there
is additional hidden problems. Any hint of fraud should eliminate an
investment from consideration for purchase. This usually results in
further declines in the stock or bond price.
Real
value investments will have transparent financial reports and
credibility with investors. Quality companies with sound management will
demonstrate openness and honesty with their successes and failures.
5. Balance Sheet / Debt
The
balance sheet may be more important than the income statement for
sorting out value traps. High debt can cause problems with liquidity and
solvency that can sink an otherwise good business plan. A highly
leveraged company has less leeway for making mistakes or overcoming
obstacles.
A
strong balance sheet is the foundation of a quality company and
provides a margin of safety. When a company faces adverse conditions a
conservative capital structure gives them the financial flexibility to
meet the challenges.
6. Strategic Advantages
A company that lacks strategic advantages to overcome tough competition or heavy regulations can lose their ability to compete. In today's cutthroat global markets a company must have sustainable competitive advantages. Before purchasing a cheap stock be sure the company has competitive advantages that will provide the cash flow and growth needed to raise the price of the stock.
Does
the company have the ability to stay ahead because they are a market
leader, have economies of scale, pricing power, differentiation of
product, cost benefits, or have powerful brands. Without one or more
competitive advantages the company may not be able to thrive.
7. Look Forward Instead of Backwards
A
stock may look cheap when compared to its past earnings. But the market
values companies on future earnings and growth of those earnings. What
a company has earned in the past will have little to do with its value
today.
Most
financial sites quote P/E ratios based on past earnings. Looking
forward means estimating future earnings and cash flows; then comparing
those metrics, not past metrics, to the current price
