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Value Traps And Real Methods To Avoid Them

Value Traps And Real Methods To Avoid Them

Table of Contents

A value trap is a stock that appears cheap because of trading at low cash flows, large price fall, and low multiples of earnings for a long period of time. Since these stocks are inexpensive they tend to attract investors who are looking for a bargain in the stock market. While it looks like a bargain price, this price is usually low for a good reason. These companies are normally experiencing a fundamental change hence could easily be dying. Trading that occurs at low cash flows for an extended period of time may indicate that the company or the whole sector is in problems and that stock price may not go up in future.

How to avoid value traps

Look beyond P/E ( price to earnings ratio)

price to earnings ratio

When looking for an investment opportunity, never get excited about what is looking cheap because of its low price. In any case, it’s not enough to look at the stock’s current P/E. To get a sense of its normal range, it’s very important to also look at the history of the company and check out its earnings and any forward earnings estimates if it’s available. This will help you identify the best company to invest in. This is one of the best investing strategies.

Avoid a firm that lacks a competitive advantage

competitive advantage

Normally, every market is very competitive. If you can’t see that a company has a competitive advantage, then it may not have one. You need to consider the potential sources of competitive advantage such as brand identity, propriety technology or unique products, less expensive suppliers and cash reserves. Unless a company has at least one of these to allow it succeed more than its competitors, it’s not likely to grow. This also applies to its stocks as well.

Having bad business model

Regardless of how promising a company’s statement may seem and how attractive its stock price may appear, you need to be very careful about a company that does not have a business model that is easily understandable and focused at being profitable. If you cannot clearly see how the company’s business model should lead to profitable revenues then it’s good to avoid its stock. More so, be careful of companies that still use outdated technologies. A company that still offers outdated products or services in the current economic environment is in serious problems.

Too much debt

Too much debt

Many promising businesses have been sent to bankruptcy by being overly leveraged. If a company’s stock price and revenues have declined the interest on its debt becomes a larger percentage of its income and revenue. When this occurs the debt becomes very hard to manage. A company that has a higher debt load has very little room for minor setbacks in the market. It’s, therefore, vital to avoid stocks that have a higher debt to equity ratio than what is averagely in the industry or the stock market.

Beware of companies faced with very stiff competitions

competition

It’s very important to look at the profit margins of a company through a period of between 5 to 10 years. You need to compare this to the profit margin of its competitors. If the profit margins have been increasingly decreasing it means that the company cannot pass these costs to the customers since it needs to maintain competitive prices. It’s, therefore, better to avoid such a company regardless of its low valuations.

Well, these are some of the ways to avoid value trap. The most important thing is to carry out a stock valuation before investing. If you like this article please share with your connection and enjoy your trading journey.

About Satish Oraon

I'm a good computer programmer & head of forex and crypto analyst, after finishing my programming like to trade & analyze forex, crypto and different trading assets.

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