Why You Should Avoid the So-Called Cheap Stocks (WTW)

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When hunting for stocks to buy, it’s always great to find bargains. But investors should also proceed with caution when shopping on the sale rack; in plenty of instances cheap stocks are cheap for a reason.

Why You Should Avoid the So-Called Cheap Stocks (WTW)For instance, I reminded investors to look cautiously at any stock with a price-to-earnings ratio below 9 in a recent Facebook investor tip of the week. While it’s important to consider the P/E ratio to make sure you’re buying shares at reasonable value, a single-digit number is generally a red flag for investor sentiment and company outlook — meaning it should definitely be a catalyst for extreme due diligence.

For proof that a P/E ratio under 9 can indicate a rough road ahead, consider Weight Watchers (WTW).

Right now, Weight Watchers sports a P/E ratio just above 3. Again, in a bubble, one might be tempted to think that signals WTW stock is a screaming bargain. Instead, it would be better classified as a value trap, as WTW stock has been in a near free-fall for some time thanks to the deadly combination of an outdated offering facing increased competition.

Take a look at the one-year and five-year charts, courtesy of Google Finance:

Why You Should Avoid the So-Called Cheap Stocks (WTW)

Source: Google Finance

WTW One-Year Chart

Why You Should Avoid the So-Called Cheap Stocks (WTW)

Source: Google Finance

WTW Five-Year Chart

Right now, shares of Weight Watchers stock are trading for just under $5 … but they fetched as much as $85 back in 2011. The reason for the fall is obvious: Revenue and earnings have been heading nowhere but down of late, as seen in the two charts below, courtesy of Yahoo Finance.

Why You Should Avoid the So-Called Cheap Stocks (WTW)

Source: Google Finance

WTW Revenue

Why You Should Avoid the So-Called Cheap Stocks (WTW)

Source: Google Finance

WTW Earnings

Looking forward, Weight Watchers is only expected to post earnings growth of 2% per year — a drop in the bucket, especially considering we’re starting from such a low base. For all of 2015, earnings should tally just 57 cents per share versus more than $2 per share a year ago. Things get worse in 2016, with a mere 43 cents per share on tap.

Reversing that downward trend won’t be easy, either, considering the dieting world is so fad-focused — and it seems WTW’s glory days are in the rear view. This is especially true in the wake of a move to mobile, which is hard to effectively monetize and which is making the space even more crowded.

The bottom line: Weight Watchers is anything but a bargain. Instead, it’s low P/E ratio is a symptom of larger and arguably incurable issues. It only takes a quick look at a few fundamental metrics to see that — but the single-digit P/E provided a nice shortcut.

This, of course, is just one example of the problem with low P/E ratios … and it’s important to remember there’s far more nuance to the term, as I’ve nodded to before. For instance, the denominator of “earnings” is easy to manipulate with various accounting principles, which can affect the appeal of the metric.

Additionally, premiums vary dramatically across industries — sometimes a high P/E ratio doesn’t necessarily mean a stock is overpriced, but poised for growth. So not matter the situation, be sure you do some extra digging before you press “buy” based on the P/E ratio alone.

Still, more often than not, a single-digit ratio is enough of a red flag that you can cross such “cheap stocks” off your buy list immediately.

Hilary Kramer is the editor of GameChangers and Breakout Stocks Under $10.

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Article printed from InvestorPlace Media, https://investorplace.com/2015/06/why-you-should-avoid-the-so-called-cheap-stocks-wtw/.

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