Jim Cramer considers it his job to make sure that investors don’t let Thursday’s market bounce lure them into value traps. He sees a ton of value-trap stocks lingering out there, and they could be incredibly dangerous.
A value trap is a stock that appears to be cheap because it has a low price-to-earnings multiple but is deceiving because the actual earnings estimates are too high. So, when the numbers come down, the stock gets crushed.
“This can be a difficult concept for people, since the price-to-earnings multiple or P/E ratio, is the No. 1 metric we use to value stocks and determine whether they are cheap or expensive,” the “Mad Money” host said.
Many use the P/E ratio as a tool to figure out what the market is willing to pay for a company’s future earnings. Stock prices can vary widely, so the P/E ratio can be considered an apples-to-apples comparison.
To calculate the P/E ratio, investors can divide the price-per-share of the stock by the earnings-per-share.
But be careful.
Typically if a stock has a low P/E ratio, investors view it as being inexpensive. However, there are stocks with incredibly low P/E ratios that can languish for years or even be obliterated.
“Those are value traps and they can fool you if you don’t know what to watch out for,” Cramer said.
Read more from Mad Money with Jim Cramer
Cramer Remix: This stock could be a heartbreaker
Cramer: China could fall another 28%
Cramer: Market oversold—start picking these stocks
To determine if a P/E ratio is suspicious, Cramer said to keep in mind that valuing stocks has two components. The first is the fluctuation of multiple, or what he will pay for earnings and the other part of the equation are the actual earnings themselves.
If the earnings estimates are too high, then a very low multiple can be a red flag. This signals that the numbers may have to be cut. Rising and falling earnings estimates are the top driver of stock prices.
Consider the case of Ensco, one the world’s largest offshore oil drillers. Right now the average stock in the S&P 500 sells for about 16 times earnings. Ensco appears to be incredibly cheap, trading at just 4.7 Wall Street’s estimate of $2.27 per share.
Given that Ensco’s stock is down 80 percent in the past two years, one might think that this would be an amazing bargain — but that would be wrong.
The problem is that the reason why the P/E ratio looks so low right now is because earnings estimates are still too high. The company’s core offshore drilling business is eroding quickly, especially with crude down at $31 a barrel.
Cramer interprets the low multiple as a signal that investors do not trust that Ensco will even come close to meeting the earnings estimates. That makes this a prime candidate for being a value trap stock, and Cramer thinks it can go lower. Once investors lose faith in earnings, the P/E ratio is meaningless.
“If today’s buoyant market makes you want to pick stocks with low price-to-earnings multiples that have already been hammered, just remember that not everything with a low multiple actually counts as cheap,” Cramer said.