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.
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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.