Cheap Stocks Or Value Traps?

By Investopedia Staff AAA

Under certain infrequent circumstances, a stock will trade for less than the amount of net cash per share on the company's balance sheet. Net cash per share is defined as cash and equivalents less total debt, divided by the total number of shares outstanding of the company. While such a stock may appear to be an irresistible bargain, a considerable amount of analysis needs to be undertaken to determine whether it is indeed a good deal, or is simply too good to be true.

Net Cash Per Share
As an example, consider a hypothetical company called Bargain Basement Co. (BBC), with stock that is trading at $10, with 10 million shares outstanding. Assume that this company's latest balance sheet shows a cash holding of $150 million, with total debt of $25 million. Therefore, the net cash balance (cash less debt) amounts to $125 million, and net cash per share is $12.50.

Why is the net cash figure used, rather than just the cash amount on the balance sheet? Because the object of the exercise is to evaluate the net cash amount that would theoretically be received by equity shareholders in the event of the company's liquidation. Therefore, any debt outstanding has to be subtracted to arrive at the net cash figure.

Note that the net cash per share metric does not consider the value of other assets, such as inventories. Therefore, it only provides part of the picture as far as a company's value is concerned, whereas a measure, such as tangible book value (book value less intangible assets, like goodwill) may provide a more complete picture.

Enterprise Value
Here's another way of looking at this metric. A company with stock that is trading below its per-share cash value will have a market capitalization that is less than the net cash amount on its balance sheet. In the previous example of BBC, the company has a market capitalization of $100 million, as compared with its net cash balance of $125 million.

In other words, the enterprise value of BBC is -$25 million. Enterprise value is the value of the whole business; in its simplest form, it is defined as market value of equity plus debt minus cash and equivalents. In BBC's case, this works out to $100 million (equity) + $25 million (debt) - $150 million (cash).

The value of a company lies in its ability to generate positive cash flows years or decades into the future. But how can a company have a negative enterprise value, or be valued at less than its cash holding?

When Does a Stock Trade Below Cash Value?
As is to be expected, stocks rarely trade below cash value. However, under certain circumstances, such as those listed below, they may do so.

  • In bullish markets, since investors are willing to pay higher valuations for stocks, they seldom trade below cash value. However, during a protracted bear market - when uncertainty reigns and valuations collapse - it is not unusual to find a significant number of stocks trading below cash value. In October 2008, for example, as global financial markets were caught up in an unprecedented selloff, more than 875 stocks were reportedly trading below the value of their per-share cash holdings.

  • Stocks trading below net cash may be clustered in a specific industry or sector if investors are extremely bearish regarding the prospects of that sector. For example, following the "tech wreck" of 2000 to 2002, a number of technology stocks were trading below the value of their net cash holdings.

  • A stock may also trade below cash value if the company operates in a sector such as biotechnology, where a high "burn rate" (the rate at which cash gets used up for operations) is the norm and the payoff is uncertain. In such cases, this may signal that the market views the company's cash balance as only being sufficient for a few more quarters of operations.

  • Stocks may also trade below cash value when there is a great deal of uncertainty about the valuation of assets and liabilities on the balance sheet. During the ferocious bear market of 2008, a number of banks and financial institutions traded below cash value for this reason.

Sign of Value or Impending Failure?
The fact that a stock is trading below its cash value may be an indication that investors think the company is worth less as a going concern than it would be if it were wound up or liquidated (and the proceeds distributed to investors). This generally indicates an extremely pessimistic view of a company's prospects that eventually may or may not prove to be justified.

A stock trading below cash may be a true value stock in situations where the pessimism surrounding its prospects is not justified. This could occur when a company is in the early stages of a turnaround and its business outlook is improving, or when a company is developing a drug or technology in which the chances of success are viewed with undue skepticism by investors.

A stock trading below cash value may signal impending failure in cases where the company may be unable to raise additional capital before its cash runs out, or there are significant liabilities that may not be apparent on the balance sheet (as for example, a pending lawsuit or environmental issues).

In most cases, as noted earlier, a stock that is trading below net cash per share is not necessarily a bargain, and it is necessary to look behind the numbers to identify the reason for the anomaly.

When to Invest
Broadly speaking, it may be best to invest in stocks trading below net cash when market sentiment is positive and equities are in a firm uptrend. As such, the best time to do so is at the start of a new, sustainable bull leg, before such stocks attract broad market attention. In 2003, for example, investors were able to reap substantial gains on select technology stocks that had traded below cash value for months beforehand.

Note that the majority of stocks trading below cash value are likely to be small-capitalization stocks that have been ignored by investors and the media. There is generally too much investor and media interest in larger stocks for them to trade below cash value for long. Small-cap stocks have their own unique risks, and investors looking to invest in them must ensure that they are familiar with these risks and can tolerate them.

A stock with sound fundamentals will seldom trade below cash value for long. Once market sentiment improves, investors usually catch on and stampede into it, thereby driving up the stock price. Otherwise, it is likely to be acquired by a rival company.

The Bottom Line
The initial impression of a stock that is trading at less than net cash per share may be that it is a bargain. However, it is recommended that an investor contemplating an investment in such a stock do a significant amount of analysis and look behind the numbers to ascertain whether it is a genuine bargain or a "value trap."

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