Our ideal stocks are companies that are growing fast, have a strong moat against competition and are selling at a reasonable price. But sometimes we see stocks that may not meet all those criteria but appear so bargain priced we’re tempted to buy them and simply wait to see if the companies can turn around.

They might, but if they don’t go anywhere for years or, worse, go the wrong way, those allegedly cheap stocks can put areal hurt on our portfolios’ returns. Professionals call those dead stocks “value traps.” If the stock plummets, then they’d say we “caught a falling knife.” Ouch.

Great companies can be unattractive stocks and rotten companies can turn outto be great investments. The one factor both these extremes share is prices that don’t reflect their economic value. We want to invest in bargains but how canwe protect ourselves against value traps?

First, we’ll look at the structure, strengths and weaknesses of a couple of common metricsand then we’ll put together a checklist that will help you decide whether the stock might languish or has the potential to skyrocket.

Price-to-Book Ratio
If you could buy a $100 bill for $80, you’d do it in a heartbeat, right? That’s what many value investors hope to do: They want to buy a company’s assets for pennies on the dollar. The measure many investors rely on is the price-to-book ratio (P/B), which divides the com­pany’s stock price by its book value per share. If the stock price is less than the book value per share, they presumably would be getting a bargain.

The challenge comes from how book value is computed. The book value of the company comes from subtracting the liabilities and preferred stock from the assets of the company. What’s left is the common shareholders’equity.

But assets and liabilities are estimates born of accounting rules. Many of them aren’t remotely hard numbers. For example, a factory’s value might be reported on the asset side of a balance sheet as the original cost of the land and the construction minus accounting depreciation. The land and the factory might be worth far more because of the land appreciating or it could be far less because the factory is making an obsolete product. Assets may include goodwill, an intangible asset that comes about from buying another company at more than fair market value of the acquired assets.

Liabilities could include estimates of a lawsuit they expect to lose and how much they can owe in pensions to workers who might retire in 20 years. They might overestimate warranty repair costs or how many of their outstanding invoices they’ll collect.

Analysts frequently adjust reported assets and liabilities to make more accurate estimates of the company’s true worth.

Even with these caveats, price-to-book is a useful metric. Stocks with low P/B ratios have historically done better than those with higher ratios.

Price-to-Earnings and Price-to-Cash Flow
Price-to-book is derived from the value of the com­pany’s assets, but what if a company has a small asset base but generates high profits? Price-to-earnings is popular among investors because it’s both simple and adaptable. It’s useful in comparing companies in the same industry, across industries and comparing the com­pany’s current valuation against historical levels.

Since earnings, like assets and liabilities, is an accounting construct, we need to be confident the companies we’re comparing have similar accounting policies. If not, we may be comparing apples to oranges. That’s why many analysts prefer price to free cash flow. 

There are two different measures to free cash flow. The first is free cash flow to the firm (FCFF), which is the cash available to pay debt and distribute to owners. Unless the firm is distressed, we shareholders are more concerned with free cash flow to equity (FCFE). 
 

FCFE simply looks at the amount of cash the company generates that can be distributed to shareholders or reinvested into new projects. It can be calculated a variety of ways, but the simplest is to use the company’s statement of cash flows and add net debt issued (which generates cash) and subtract capital expenditures (CapEx), which is required to keep the company’s physical assets in working order.

Analysts often adjust that CapEx figure to match economic reality. Expanding companies might be making higher capital expenditures to increase their manufacturing capacity. That’s a discretionary use of cash and a value-focused investor may increase the free cash flow figure to ensure the P/FCFE ratio isn’t too high. Like P/B and P/E, P/FCFE is a treasured tool in analysts’ kits.

Turnabout Is Fair Play
A low valuation multiple doesn’t mean the stock is a bargain because, unless the stock is at zero, what’s low already can go lower still. What you want is not to catch a falling knife but see a tennis ball bounce. You should look for a catalyst that will compel the market to re-evaluate the stock and value it at a higher price than before. Some examples of potential catalysts include new management, cost cutting and streamlining product lines, new products, new partnerships and new customers. The questions you should ask yourself about any potential turnaround theme are:

Is it material?
Will this catalyst have enough of an impact on the company’s future profitability or its acquisition value to drive the stock price high enough to be worthwhile? Companies frequently announce pilot initiatives that sound exciting, only to allow them to die unheralded a couple years later. Another possibility is the initiative might be compelling, but it’s too late. The company might not have the resources to survive long enough to profit.

Do you understand something the rest of the market doesn’t? 
It’s not enough for an announcement to be material, either. The rest of the market will have access to the same information as you. That means you need to apply insight. This is where industry knowledge might come in handy. Has the market become too pessimistic about the company, while you believe the company is well-positioned?

Your default assumption should be that all news will be quickly digested by the market and priced into the stock. Occasionally, there will be situations when it appears abundantly clear to you the market is missing something.

One example that comes to mind was Harley-Davidson’s (ticker: HOG) roll out of a performance oriented adventure bike that didn’t sound, perform or look like anything the company produced over the past century. The media was skeptical. The Pan America Special has been a raging success and dealers can barely keep it in stock.

Disclosure: Your humble columnist here bought one (but does not own the stock). When I bought it, mymechanic was convinced the company was either going to be bought or fold. Now he’s considering buying one. That’s not a recommendation to buy Harley’s stock, but it is an excellent example of an information mismatch.

Will the market notice?
News on small-cap stocks is often reminiscent of a tree falling in an uninhabited forest. If no one cares about the stock, no one will bid the price up on good news. Even large- caps can announce major news that gets lost in the current 24/7 news cycle.

There are few things more rewarding than being right and thousands — sometimes millions — of other investors being wrong, especially if they come around to your way of thinking, while paying for the privilege.

Over a long enough career, that will happen to you, too. There will be many tempting stocks. But, for those plays to have a mean­ingfully positive impact on your returns, you should require compelling evidence you’re applying solid insight instead of simply buying some stock cheap.