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Beware the debt trap when investing in recovery stocks.

Jim Armitage
·1-min read
 (AFP via Getty Images)
(AFP via Getty Images)

It’s easy in bull markets to focus on the momentum in a share price and forget about what lies beneath.

High prices are justified by comparing the price-to-profit ratio with rivals or historical levels.

If the multiple is lower, the shares look like a bargain, so investors buy them.

Coming out of a recession, that’s a very dangerous game.

For, while the shares might look cheap against those comparisons, it may be that the company has a whole load of debt and other nasties (pension liabilities, leases and the like) that have built up during the crisis.

Only when you add those to the price of the shares do you get the whole picture. This is called enterprise value, or EV.

So, when deciding whether to buy, sell or hold, it’s worth looking at the EV/profit ratio rather than just that of the share price/profit.

Carnival Cruises offers a prime example.

As a Shore Capital research note says today, the share price has doubled from the Covid trough, yet it’s still down at 2009 levels.

A raging buy, then, yes?

No. Because if you add the mountain of new debt Carnival has taken on to survive Covid, the company is currently valued at close to all-time highs. Its EV/profit multiple is 10 compared with 7-8 before the pandemic.

If you think an inevitable result of the pandemic terror is that record numbers of older folks will flock into enclosed spaces on cruise liners, Carnival may still be a buy.

Otherwise, think of the debt and jump ship.

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