Cheap stocks can get cheaper. They often do.

Unfortunately, "cheap" is a relative term. Precious few stocks that trade for low price-to-earnings ratios or below book value are real bargains. They look enticing, but instead, they're value traps -- stocks that deserve the multiples for which they trade, and punish the garbage-grabbers who buy them.

But don't take my word for it. Here are five "cheap" stocks that trapped bargain-hunting prey:


CAPS Stars
(out of 5)

2004 Price-to-Book Ratio

Return Since

Lexington Realty Trust (NYSE:LXP)




Flextronics International (NASDAQ:FLEX)




Radian Group (NYSE:RDN)




LeapFrog Enterprises








Sources: Motley Fool CAPS, Capital IQ, Yahoo! Finance.

Watch out!
How can you avoid value traps like these? My favorite method is borrowed from Professor Aswath Damodaran. In his book Investment Fables, Damodaran counsels investors to measure low price-to-book stocks by their returns on equity (ROE).

Makes sense to me. "Book value" is shorthand for "equity." A low price-to-book stock is priced as if management won't produce high returns from the equity capital afforded it. Find a stock that defies this maxim -- a stock with an above-average and rising ROE -- and you may have found a bargain.

A machete for when you're in the weeds
Our 140,000-member-strong Motley Fool CAPS database is a great place to start your search. I ran a screen for well-respected stocks trading for less than twice book value, and whose returns on equity were 10% or more. Qualifiers were also trading no more than 25% above their 52-week low, leaving plenty of room for further gains.

Of the 18 stocks that CAPS found hiding in the weeds, specialist biotech Cephalon (NASDAQ:CEPH) intrigues me most this week. The details:



Recent price


CAPS stars (out of 5)


Total ratings


Percent bulls


Percent bears






% Above 52-week low


Sources: CAPS, Yahoo! Finance.
Data current as of Oct. 23.

Typically, I prefer to leave biotech investing to experts such as Brian Orelli and my Motley Fool Rule Breakers teammate Karl Thiel. But Cephalon is uncommonly appealing to me for two reasons:

  • At less than 9 times forward earnings, the stock is priced below peers GlaxoSmithKline (NYSE:GSK) and Johnson & Johnson (NYSE:JNJ), and what the Street expects from the underlying business in terms of earnings growth.
  • Cephalon has a popular product -- Nuvigil -- for treating sleep disorders, which afflict 60 million Americans. The FDA is currently reviewing Cephalon's petition to allow Nuvigil for treating jet lag; approval could lead to high-margin income gains.

But that's my take. What would you do? Would you buy shares of Cephalon at today's prices? Let us know by signing up for CAPS today. It's 100% free to participate.

Want further guidance? Get 30 days of free access to the Fool's Inside Value service, which spotlights stocks that Mr. Market has put on sale. Johnson & Johnson is an Income Investor recommendation. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Tim Beyers is also a member of the Rule Breakers stock-picking team. Tim didn't own shares in any of the companies mentioned in this article at the time of publication. Check out his portfolio holdings and Foolish writings, or connect with him on Twitter as @milehighfool. The Motley Fool is also on Twitter as @TheMotleyFool. Its disclosure policy is a bargain at any price.