(FORTUNE Magazine) – Four years ago, when Kmart's stock was ravaged by rumors of bankruptcy, it became a favorite of value investors. "It looked cheap relative to both book value and sales," says money manager Jeff Matthews of RamPartners, "but it had a flawed business model." And we know how that ended. When Kmart filed for bankruptcy last year, those value investors didn't get so much as a Martha Stewart doily.

Welcome to the classic value trap.

Right now, with prices of so many companies down so much, value traps are everywhere, tempting investors with the lure of the cheap. In theory, a value stock is the stock of a beaten-down company that is inexpensive relative either to earnings, its peer group, or some other benchmark. Often investors pin their hopes for a turnaround on such catalysts as new management, breakthrough technology, or a rejuvenated product line. Take the examples of J.C. Penney and Office Depot--two value stocks that truly lived up to their billing. Both have more than doubled in the past year and a half. A value trap, by contrast, is a stock that looks cheap but ain't. Investors get so focused on one part of the story that they overlook problems with the balance sheet, historical valuations, and, yes, the business model.

Which brings us to trap warning No. 1: debt. "The thing Wall Street continually misses is the balance sheet," says value investor Arne Alsin of Alsin Capital Management in Portland, Ore., a CPA who was raised in a family of CPAs. Such was the case with Exide, the battery company, which sucked in investors in late 1998 when it installed Detroit legend Bob Lutz at the helm. Even a star manager, however, couldn't overcome an onerous debt burden; Exide filed for bankruptcy in April 2002. Let's not forget what Warren Buffett said: "When a management with a reputation for brilliance takes on a business with a reputation for bad economics, it's the reputation of the business that remains intact."

Then there's the dividend snare--you know, a stock is cheap relative to earnings, plus you're being "paid to wait" with a big fat dividend. That was the story at Polaroid for the longest time. At one point in 2000, the stock yielded a juicy 10.5%--nice! The only problem: The share price sank lower and lower until finally the company went belly-up. Remember that dividends are often high for a reason!

Next are stocks that attract buyers because they look cheap on a historical basis. "The typical investor will see something down a lot, like IBM or Cisco or Sun, and think, 'It's time to go bargain hunting,'" Alsin says. Before you train your rifle, however, make sure to consider external factors that may have skewed valuations. IBM now trades at 1.7 times sales--far below the 2.5 times sales it fetched in the bubble years. But Alsin argues that those were inflated valuations, which is why he prefers to look at the period from 1990 to 1997, when IBM sold for around one times sales. That translates to a $50 stock, not to an $85 stock (its current price).

Also be cautious of stocks that are touted as cheap relative to their high-multiple peers. That's the pitch on videogame maker Take-Two Interactive Software, vs. the likes of Activision. Take-Two trades for 15 times this year's earnings, compared with Activision's multiple of 31. But Take-Two has only one hit game (the ultraviolent Grand Theft Auto), pumps far less into research and development than Activision, and is currently the focus of an SEC probe. "Invariably the bull case isn't that the cheaper company has good products; it's that it's cheap vs. another company," says Marc Cohodes, of Rocker Partners, whose firm is short Take-Two. "The next places you'll see it happen are restaurants and retail." (Don't ask him for names, though; both of those groups are currently flying, and the losers aren't yet apparent.)

Finally, even if all these trap signals turn out to be false alarms, make sure you see some evidence that business trends are improving before you buy that value darling. That last step is what spurred one of my top hedge fund sources to buy Gillette at around $27; it now trades at $37. The clincher: His contacts at drugstores told him that at the end of the first quarter of last year, Gillette did not come around offering discounts on its products. It was the first time it hadn't done so in years.

Still, detecting a trap is easier said than done. Even the best money managers have been snared. "If everybody knew it was a trap," reasons Matthews, who admits to once owning Kmart, "it wouldn't be a trap." Can't argue with that.

Herb Greenberg is a senior columnist for TheStreet.com. Questions? Comments? Contact him by e-mail at herb@thestreet.com.