This article is authored by MOI Global instructor A.J. Noronha, Partner, Equity Research & Portfolio Committee of Desai Capital Management, based in Chicago.

As longtime value investors, we have noticed that there is frequently a fine line when distinguishing between stocks that provide true underlying value and stocks that are merely cheap for various reasons. Experience is often the best teacher, and through close review of both our winning and losing investments over the years, we have identified several factors which continue to play a valuable role in our investment approach and which we believe can help other investors avoid value traps and find truly valuable investment opportunities in an uncertain market. We hope you find this helpful, and welcome any feedback.

Value Trap #1: Price/Book

We commonly use trailing P/E, forward P/E, P/B, and enterprise value/EBITDA to give us an indication of the relative value of a stock in comparison to a peer company or the greater market (e.g. S&P 500). The first mistake we make is using the wrong metric. P/B is relevant when you are speaking of financial services companies, REITs, or other companies with large amounts of regularly measured assets. It is largely irrelevant when it comes to technology companies or companies with large amounts of intangible assets. Book value measurements also allow for large deviations regarding intangible and inventory write-downs, making these areas to watch for value traps. Compare Intel and Apple. When it comes to inventory, Intel’s products tend to become obsolete & are replaced more quickly, making their book value quite different from Apple’s longer-lasting products.

Similarly, it is hard to accurately predict assets of companies that buy a large number of patents. For example, pharmaceutical companies have great risk when it comes to measuring the potential value of in-process drugs. The patent value is only measurable at the point of purchase and will fluctuate greatly with every milestone, creating substantial uncertainty throughout the R&D process and making the value of this intangible asset very hard to measure and thus hard to draw comparisons across companies or industries.

Value Trap #2: Price/Earnings

P/E can be a good comparison when it comes to companies with very similar capital structures. However, companies very frequently can have low P/Es when they choose to finance heavily with debt, creating another potential value trap and making P/E a less accurate gauge of relative value. The airline industry during the financial crisis provides us with a great example of this. Delta, United, US Airways, American, and Northwest all declared bankruptcy while sporting low P/Es that were the result of high levels of debt. While they might appear to be a bargain at a superficial glance, a deeper look would show that they essentially become substantially more risky and expensive when you factor in bankruptcy risk. Southwest, which had a higher P/E, was more conservative with its use of debt and thus did not require bankruptcy protection.

Value Trap #3: Enterprise Value & EBITDA

Finally, enterprise value/EBITDA takes into account all capital sources but requires greater inspection of debt structure, tax treatments (deferrals, loss carryforwards, international operations) and various methods of depreciation. In order to accurately compare different companies using this metric, adjustments would have to be made to reflect each of these factors. In the case of GE, they pay a much lower tax rate than the 35% US corporate rate, have many international subsidiaries, and have significant depreciation of industrial plant and equipment. To compare them to another industrial company of a similar scope would be costly and time-consuming. However, a consistently profitable company with operations that are predominantly in the same country can typically be used as a reasonable comparison.