Without significant skills or luck, you are likely to get hurt "catching a falling knife.” In the market, this refers to purchasing a stock that has dropped significantly in value and may be trading below historical or intrinsic values. When faced with this scenario, follow the same philosophy as a four-year-old child: keep asking, "Why?" If you don't get a suitable answer, don't invest.
A company's stock may be beaten down for many reasons, from poor fundamentals to overreaction. When deciding whether a company is a value purchase or a value trap, assess the collective financial information available (income statement and balance sheet information, along with valuation ratios), and then investigate the company further to look for non-financial factors driving down the stock price.
Valuation ratios and company financials to consider include:
- Price-to-Earnings Ratio (P/E) and Price/Earnings to Growth Ratio (PEG) – The P/E ratio is the common stock price per share divided by the after-tax earnings per share, and the PEG is the P/E ratio divided by the estimated growth in earnings per share.
P/E and PEG ratios typically use earnings over the past 12 months, but they can also be based on earnings estimates (called "trailing" and "forward" respectively). You are interested in future growth, thus forward P/E or PEG ratios are preferable.
P/E ratios should be compared to similar companies. PEG's of less than one are preferred, especially if they are forward PEG's based on a sound reason for improvement.
- Cash Flow – Earnings can be manipulated, but cash cannot. Consider the Net Cash Per Share, which subtracts debt from the cash holdings and displays the surplus cash on a per share basis to compare to the stock price. Any stock trading at or below the net cash per share had better have a good reason why, such as being in the early stages of a turnaround.
- Debt – Relatively high debt is often a sign of trouble. The Debt-to-Equity ratio is the long-term debt divided by the book value (assets minus liabilities) and should be below one – otherwise, they have more debt than they are currently worth, and it is unlikely earnings will increase enough to cover interest charges and still promote growth.
- Dividends – Do recent dividends seem out of line with other factors, such as P/E ratio and debt? Disproportionate dividends suggest the company is trying to squash investor concerns, while cutting dividends may mean that the company doesn't have enough funds to pay them.
Next, consider some non-financial factors:
- Reasons for Optimism – Are new product launches on the way? Has there been a positive restructuring of management? Have they landed a new contract? For you to invest, there must be some tangible reason to expect things to change.
- Sector – Is the company in a cyclical or irregular industry like semiconductors or biotechnology, with huge R&D costs and irregular payoffs compared to the burn rate of cash? If so, is there reason to expect a positive change?
- Market Share – Is the company's market share shrinking or growing? The combination of shrinking market share and/or a bad P/E ratio can certainly be a red flag. How do their profit margins compare to those of their competitors over the last few years? In other words, are they going through a rough stretch or entering a death spiral?
The bottom line is to look for as many good fundamentals as possible to offset the price, and suitable reasons that explain the current valuation ratios and why they should improve. If you're going to catch knives, do your homework – or you better invest in Band-Aids.