Cheap shares or value traps? 3 clues I look for

Sometimes it looks like a cheap stock. Maybe they’re just selling for multiples of earnings, or they’re looking cheaper than the explosive growth prospects the business likes.

But what looks like a cheap stock can be a value trap. Here are three red flags I look for when I find shares that seem cheap at first glance.

1. Exceptional earnings

Sometimes companies benefit from a sudden increase in revenue but it is ultimately unsustainable.

This is the story of the latex manufacturer Synthomer, for example. As demand for items like surgical gloves increases during the pandemic, so do profits and profits. But this would not last and the company began withdrawing dividends.

If I had bought Synthomer a year ago based on the new performance, I could have tumbled into the value trap. Shares have fallen 46% since then.

But I think Synthomer is a great company and has interesting long-term prospects! The issue I will face buying a year ago and holding until now is not very business Synthomer, but instead it was overpriced 12 months ago relative to its future prospects.

A value trap does not necessarily mean that I buy into a rotten business. It can only mean that I bought into a very good business but at a rotten price.

A common reason is to look at a company’s past earnings, without rigorously evaluating its future earnings potential. No matter how often we are told”Past performance is not necessarily a guide to future performance”, remains true.

2. Dragged by debt

This isn’t the only way you can misidentify stocks that are considered undervalued when using the price-to-earnings (P/E) ratio as a valuation metric.

Sometimes a company may look very cheap when comparing its profits to its market capitalization. But market capitalization is not the same as company value. Enterprise value also includes the company’s debt or net cash.

For example, cigarette manufacturers Imperial brand trading at a P/E ratio of less than 8. That looks cheap. But it ended last year with net debt of £8.5bn. That’s 9% lower than the previous year but still a lot.

In 2020, the rice rice producers cut dividends because of the priority of reducing debt. A lot of debt on the balance sheet is always an important factor that investors should consider when deciding whether to invest.

3. Probability problem

Sometimes investors see miners selling pennies per share and think they’ve found a cheap stock.

Maybe they have – but often they don’t.

When considering the value of a stock, just think about how much money the business can make if it is not profitable in my view. In fact, it can be positively dangerous.

I think one should also consider it objectively probability of certain results. As an investor, I try to understand the different possible outcomes – but also the likelihood of them happening.