The High Price of Cheap Stocks

RadioShack's shares looked cheap right up until they weren't. Should investors dumpster dive for RadioShack or invest in quality like Wal-Mart?

Jul 17, 2014 at 1:00PM

RadioShack (NYSE:RSHCQ) got its start as a nerd's paradise. Every kind of cable, widget, tube, model or gadget you wanted, they had it. Here we are in 2014, and many of the world's most successful companies are tech companies like Facebook and Google -- nerds rule. But what about RadioShack?

Amid the tech ascendancy, RadioShack has cratered.When your customers are tech-savvy nerds (I mean that as a compliment by the way), they are even more likely to buy online. That spells trouble for RadioShack.

Beyond the qualitative factors that govern the success and failure of business models, there is another lesson for investors on the quantitative side -- metrics that imply cheap prices can mislead. Compared to the S&P 500's P/E ratio, RadioShack's P/E has looked like a bargain. Who doesn't like buying dollar bills for $0.50?

Unfortunately for RadioShack shareholders, they may have paid $0.50 but they did not get back a dollar bill -- instead they may have bought a quarter's worth of value. Have a look at the relationship between RadioShack's P/E ratio versus its price.

RSH Chart

RSH data by YCharts

Here is a stock that looked cheap as can be -- a single digit P/E is cigar-butt territory. It looked cheap right up until its earnings (and then price) cratered and then once that happened it looked expensive on a P/E basis. P/E is a historical metric, and driving while looking through the rear view mirror can be hazardous to your wealth. Now, RadioShack has become a distressed stock, as it has reported negative earnings since 2012. 

For an example of a more straightforward relationship between price and earnings, consider the five-year history of Wal-Mart (NYSE:WMT)

WMT Chart

WMT data by YCharts

What could have tipped off RadioShack investors that the cheap price was a facade around a failing business? 

Let's look at four metrics that all trended poorly for RadioShack. Free cash flow peaked in 2007 and steadily headed south, and it went negative in 2012. Operating margin was not high to begin with, and it peaked at 9% in 2007 and declined to negative by 2012. Earnings per share also went negative in 2012. 

RSH Free Cash Flow (TTM) Chart

RSH Free Cash Flow (TTM) data by YCharts

Was there anything to tip off investors that 2012 would turn out to be an annus horribilis for RadioShack? One line in the chart stands out. The company was unable to raise its dividend for many years before the wheels came off the wagon in 2012. A lack of a dividend raise by itself is not as big of a red flag as a dividend cut, but a lack of growth does not demonstrate that the company is a thriving business either.

By contrast, Wal-Mart has been able to deliver solid dividend growth year in and year out. The ability of a company to continually raise its dividend is an important defensive characteristic.  

WMT Chart

WMT data by YCharts

Dividend growth does not guarantee that your stock will be a high flier and generate outsized capital gains in the short run. Dividend growth does offer some downside protection by providing the ability for a company like Wal-Mart to reward its shareholders directly. A lack of dividend growth can point to worse issues cascading across a business' operations. Even if you are not investing primarily for dividends it makes sense to pay close attention to this metric to shore up your portfolio's defense. 

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Gunnar Peterson owns shares of Facebook and Google (C shares). The Motley Fool recommends Facebook and Google (C shares). The Motley Fool owns shares of Facebook and Google (C shares). Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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