One Sure Way To Avoid Value Traps
Perhaps you've been in this situation before. After doing a vast amount of research, you finally come across a stock that appears to be too good to be true. It has a strong market position along with rising profits and sales. And best of all, a price-to-earnings ratio that is really, really low - like about one-third the P/E ratio of the S&P's 500 stock index - which would place it at about 7 right now.
But you have two concerns: 1)that the company has a fair amount of long-term debt; and 2)that it's involved in a business that is extremely sensitive to the economic cycle... So what do you do?... You buy. And then you buy more when the stock goes down another 20% because after all, it has a very tiny P/E. But the stock keeps falling...and falling...and falling... Hey guess what?...Welcome to the Value Trap!
It is a very easy thing to do: losing money in the market by betting on "cheap" stocks that just kept on getting cheaper and cheaper and cheaper. The problem? These shares really weren't as cheap as their low P/E ratios indicated.
Now this is not to be construed as a total condemnation of P/E ratios as they do have a place in evaluating many prospects. But they may not tell the whole story in terms of risk. Indeed, P/E ratios, as well as book value, look solely at a company's equity value. And while they may work fine in many cases, they don't work so well for companies that have a lot of debt and/or cash on their balance sheets.
A better way to value a company while still remaining within the P/E framework is to replace its equity number in the equation with its enterprise value. A company's enterprise value is the market value of a corporation's total capitalization (debt plus equity, minus cash).
Why it's important: It gives a different perspective on a stock's valuation. Traditional P/E ratios may not fully capture the risk of owning certain stocks, especially those with debt loads.
How to calculate it: You take a stock's market capitalization (stock price times outstanding shares), add the company's long-term debt, and then subtract its cash assets. To convert to a per-share number, divide enterprise value by the number of shares. When using enterprise value per share in a P/E ratio framework, simply divide the enterprise value per share by trailing or forecasted 12-month earnings per share.
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But you have two concerns: 1)that the company has a fair amount of long-term debt; and 2)that it's involved in a business that is extremely sensitive to the economic cycle... So what do you do?... You buy. And then you buy more when the stock goes down another 20% because after all, it has a very tiny P/E. But the stock keeps falling...and falling...and falling... Hey guess what?...Welcome to the Value Trap!
It is a very easy thing to do: losing money in the market by betting on "cheap" stocks that just kept on getting cheaper and cheaper and cheaper. The problem? These shares really weren't as cheap as their low P/E ratios indicated.
Now this is not to be construed as a total condemnation of P/E ratios as they do have a place in evaluating many prospects. But they may not tell the whole story in terms of risk. Indeed, P/E ratios, as well as book value, look solely at a company's equity value. And while they may work fine in many cases, they don't work so well for companies that have a lot of debt and/or cash on their balance sheets.
A better way to value a company while still remaining within the P/E framework is to replace its equity number in the equation with its enterprise value. A company's enterprise value is the market value of a corporation's total capitalization (debt plus equity, minus cash).
Why it's important: It gives a different perspective on a stock's valuation. Traditional P/E ratios may not fully capture the risk of owning certain stocks, especially those with debt loads.
How to calculate it: You take a stock's market capitalization (stock price times outstanding shares), add the company's long-term debt, and then subtract its cash assets. To convert to a per-share number, divide enterprise value by the number of shares. When using enterprise value per share in a P/E ratio framework, simply divide the enterprise value per share by trailing or forecasted 12-month earnings per share.
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posted by Bob Moser at
6:54 PM
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