For a value stock investor, one of the most difficult challenges is determining when a stock truly is a good value and not just a value trap. This article discusses some useful indicators to help you identify value stocks.
A Value Stock’s Fundamental Business Strategy Should Be Intact
Both value stocks and value traps may look undervalued based on measures such as price-to-earnings ratios, price-to-book value per share and market capitalization-to-revenue, and both may be trading well below their highs. However, in evaluating any stock whose share price is down and, as a result, appears to be a good value based on such measures, focus on the reasons why its price has slipped.
If a company’s share price is depressed because its business strategy isn’t working, it may be a value trap. A few indicators of a value trap could be an unplanned loss of market share, margin contraction, increased competitive pressures, poor inventory control, or an acquisition that isn’t contributing as expected.
On the other hand, if a company’s share price is down for reasons that don’t appear to reflect a change in its fundamental health or long-term prospects, it may be a value stock. For example, its shares could be under pressure because its industry is out of favor; a competitor reported disappointing results; one-time, non-operating items such as settlement of a lawsuit or costs to retire debt early hurt earnings; or margins fell because the company is in the process of exiting an underperforming business.
The Answer to Value Differentiating Questions Should Be Yes
When trying to determine whether you have found a value stock or a value trap, ask yourself questions such as the following about the company: Is its brand intact? Is its market position defensible and growing? Is its fundamental business strategy rational and realistic? Are its cash flow and balance sheet in good shape? If the answers are yes, you are more likely to have identified a value stock.
There Should Be an Identifiable Catalyst for the Share Price to Rise over Time
As a value stock investor, you need to be prepared to be patient, but you want to make money in time. Therefore, when trying to differentiate a value stock from a value trap, ask yourself whether there is a reasonable argument for its share price to rise over the next 12 to 25 months. In the case of a true value stock, you may conclude that if, as you believe, the company’s business plan remains sound, this will, in time, be reflected in reported results and, in turn, in the share price. On the other hand, if you have a hard time making a convincing case for future growth without significant changes in strategy, new management, a blunder by the competition or some other unlikely event, then you may have found a value trap that is best avoided.
Ken Little, stocks.about.com, Difference Between Value Stock and Cheap Stock