After a mid-2020 to late-2021 bull run, many companies across the board have witnessed their values plunge in 2022. While bear markets can be a great time to go discount shopping and grab some great companies for cheap, they can also be a time to be wary of falling into investing traps. With many stocks currently at or near 52-week lows, value and dividend traps are everywhere. Here's how you can avoid them.
Cheap doesn't equal value
One of the best lessons you can learn as an investor is that cheap stock prices don't always equate to value. A $5,000 stock could be undervalued, and a $5 stock could be overvalued. For example, if a penny stock were priced at $5, it would likely be considered overpriced by most standards. However, if Berkshire Hathaway Class A shares were priced at $5,000 instead of the $463,400 at which it's currently priced, it'd arguably be the investment deal of a lifetime.
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It may be tempting to see a cheap stock and want to buy up a lot of shares because of the "upside," but this could be counterproductive if you're investing in stagnant or failing businesses. Instead of looking at price alone, it helps to look at a company's price-to-earnings (P/E) ratio to help determine whether a stock is undervalued or overvalued. You can find the P/E ratio by dividing a company's current stock price by its earnings per share (EPS). A quick online search can provide you with these metrics to save you time.
You can't look at a company's P/E ratio alone to determine its value, though; you need to compare it to similar companies in its industry. Some industries (like financial services) have naturally low P/E ratios, and some (like restaurants) have naturally high P/E ratios, so it could be misleading to compare across industries. You wouldn't want to compare Apple's P/E ratio to Walmart's, but you could compare it to Microsoft's.
If you notice a company's P/E ratio is lower than comparable companies, it could be a sign that it's undervalued. The same goes for it possibly being overvalued if its P/E ratio is higher than others in its industry.
Look past the dividend yield
When companies declare their dividend for the year, it's by dollar amount per share, so their dividend yields (expressed as a percentage of the stock's current price and found by dividing the annualized dividend by the current share price) fluctuate with the stock price. For example, if a company's yearly dividend is $1 and its stock price is $50, its dividend yield would be 2%. If the stock price dropped to $25, the dividend yield would be 4%; if it increased to $100, the yield would be 1%.
With many stock prices down considerably, dividend yields are noticeably higher. This is great for investors in blue chip companies like Apple, whose dividend yield is up over 40% since the beginning of 2022. It's not so great for investors who may get caught up in dividend traps. A dividend trap is a company with a too-good-to-be-true dividend yield that's unsustainable and masking an otherwise bad investment.
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A company's dividend yield is important, but instead of looking at its dividend yield by itself, you should look at its payout ratio, which lets you know how much of its earnings it's paying out in dividends. For instance, if a company makes $10 million in profit this year and pays out $2 million in dividends, its payout ratio would be 20%.
A payout ratio over 100% means a company is paying out more than it's bringing in, which is a red flag. Eventually, the dividend will either need to be cut, or the company will run out of money, and neither of those is ideal for investors. Especially if it's the dividend that attracted you to the company.
What's considered a good payout ratio varies by industry and a company's growth plans. Some industries are more shareholder-friendly with dividends (like utilities), while some are on the lower end (like tech) because companies reinvest more profits to focus on growth.
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Making sure the dividend is sustainable is more important than the number itself. As a long-term investor, you don't want to get lured into chasing short-term income and high dividend yields.
