Cheap stocks are not always good investments. Lots of people get tempted by this opportunity, and at the end of the day get trapped. The most important thing is to know about the growth prospects of the company selling cheap stock.
The cheap stock also known as penny stock can be an ultimately dangerous appeal. It always comes down to fluctuation in price as penny stocks are not always stable. Unfortunately, this can be quite deceiving as it eventually turns out to be the opposite of a high-return investment. It can end up being a total wipeout of your money.
Concept of Value Trap in Cheap Stocks
When it turns out that the market is right and you are wrong, it is called a VALUE TRAP. Value trap can be defined as a situation that makes you believe a stock is trading on a low valuation, when in fact it is not. Therefore, you can either get disappointed with future earnings or the value of the assets on the value sheet is lower.
Price and fundamental factors should be compared before one can identify a valued trap, and buy when you believe you have gotten a value stock. The popular method used to identify a value stock is Price/Book value (PBV) and Price/Earnings per share (PE).
When the mentioned above are low, you can go ahead to buy the stock. However, let it be known that it might not always work to your advantage. Here are valuation metrics that indicate value trap:
1.The Low Trailing PE Ratio
When there is a low price-to-earnings ratio, it is commonly believed that the stock is cheap. A PE ratio can be compared to its historical range to get an idea of a value stock. A low PE ratio doesn’t tell you about the future, it only makes you know the value of the stock.
For example, there might be trading at a single-digit PE multiple, and the market could be quoting below its book value or trading at over 20 times on a trailing basis. This factor only should not give you a good reason to invest in the stock. Other aspects have to be examined to see if it offers a good value stock.
PE and PBV have to be studied over a long period, for like three years. This has to be done because a one-year achievement can be staged-managed. The building blocks that make the ratio are improving.
Calculate the P/E Ratio quickly by using the free calculator given below:
2. Increased Dividend Yield
This type of value trap is set for long-term investors whereby a company’s interest rate is set low and this automatically yields high dividends. This can truly be tempting yet dangerous especially when dividend yield becomes the basis of buying a stock.
A reliable cash flow has to be generated if a company wants to pay dividends. If cash flows are continually spent on dividends payout without reinvesting in the company, revenue may fall eventually. This can result in companies cutting the dividend and eventually leads to investors losing up to 50% or more when the price falls.
3. Low Price-to-book Ratio
A good investor must evaluate a stock price by comparing it to the stock’s book value per share. A book value considers the value of a company’s assets. Shareholders make a profit by liquidating and selling the company if it is trading at a discount to the value of its assets. This is why investors don’t see the downside when a company is trading close to its book value.
Below are the reasons why book value can be misleading:
Book value does not always represent the value that is realized, it’s just an accounting term.
The book value of a company can fall due to impairments and write-downs of balance sheet assets which lead to rising in the book ratio and a fall in stock price.
Book value is only of relevance if there is a possibility of liquidation.
It is advisable to invest in long-term stock and buy a quality stock than invest in value traps. With patience and perseverance, it pays off. For this, keep your stock market basics clear, make sure your fundamental analysis is right and put into consideration other factors.
Moreover, always have this at the back of your mind that buying cheap stocks does not mean buying value stocks. It is also not a guarantee that you have struck a good deal. Hence, avoid cheap stocks as much as possible to prevent investment disasters. Ultimately, your wise decisions can save you huge money.