The Value Trap You Can't Ignore

By all accounts, falling share prices have created huge buying opportunities in many stocks. Yet just because many stocks are down 50% or more, that doesn't mean  every stock is now a screaming value.

Unfortunately, a lot of investors focus solely on backward-looking numbers. During bull markets, too many investors seek out the stocks that have already risen the most -- thereby missing out on undiscovered companies with far greater growth potential.

In bear markets, something similar happens with corporate financial results. You can find stocks trading at what appears to be unprecedented P/E ratios -- levels that a company may not have seen in years. Yet if you stop there and just press the buy button, you could easily make the mistake of your investing career.

Look forward
When you see a stock trading at a low P/E, your first reaction shouldn't be to get excited. Instead, be skeptical. Ask yourself why the market is discounting shares to such a huge extent. Often, after some research, you'll uncover the reason -- and it'll often prove decisive in changing your mind about the stock.

The most obvious reason why a low P/E can be misleading is because it's a purely temporary phenomenon. Consider, for instance, these stocks:

Source: Yahoo! Finance. "Recent P/E" figure as of this writing.

Seem attractive, don't they? Yet when you dig a little deeper, you'll see that analysts expect those earnings to fall substantially, making their forward valuations look a lot more reasonable -- and less attractive.

Source: Yahoo! Finance. "Forward P/E" figure as of this writing.

You'll see a similar phenomenon even among companies that aren't quite at the same bargain-basement P/E levels as these stocks. For instance, Sears Holdings (NASDAQ:SHLD) currently trades at less than 12 times trailing earnings -- but around 30 times forward earnings. Similarly, Wynn Resorts (NASDAQ:WYNN) fetches just a little more than 10 P/E ratio on a trailing basis -- but a more expensive 19 times forward estimates.

Stay out of the trap
As part of your due diligence process in evaluating stocks, be sure to consider the following when you see a company trading at a low P/E:

• Watch for one-time income. Often, a spike in earnings comes from extraordinary items that won't happen again. That artificially depresses the P/E, which will bounce back once earnings revert to normal.
• Use other metrics. Earnings numbers aren't necessarily as reliable as other measures of profitability, such as free cash flow. If earnings have risen without a corresponding jump in free cash flow, dig deeper to figure out why.
• Know the industry. Stocks in some sectors tend to trade at lower multiples than stocks in others. Many factors contribute to those disparities, including the fact that while some industries are relatively mature and stable, others have more significant growth prospects that justify higher multiples.
• Beware of spinoffs. Don't assume that the website you look at uses updated data. For instance, if a company spins off a unit, its price will usually drop dramatically -- but if you keep looking at historical earnings for the entire company for your calculations, you'll get a misleading P/E ratio.

One of the most difficult lessons investors learn is that to pick winning stocks, it's just as important -- if not more so -- to weed out companies with problems as it is to find good prospects. With thousands of stocks to choose from, you'll always be able to find attractive stocks. But the ability to avoid ones that have flaws beneath the surface separates the truly great investor from the average.

For more on finding smart bargains in the market, read about:

• Did Warren Buffett make a huge mistake?
• How you can find the cheapest value stocks.
• 3 examples of value trap stocks.