What is a ‘Value Trap’
A value trap is a stock that appears to be cheap because the stock has been trading at low valuation metrics such as multiples of earnings, cash flow or book value for an extended time period. Such a stock attracts investors who are looking for a bargain because they seem inexpensive relative to historical valuation multiples of the stock or relative to the prevailing overall market multiple. The trap springs when investors buy into the company at low prices and the stock continues to languish or drop further.
BREAKING DOWN ‘Value Trap’
Successful in prior years with rising profits and a healthy share price, a company can fall into a situation where it is unable to generate revenue and profit growth due to shifts in competitive dynamics, lack of new products or services, rising production and operating costs, or ineffective management. For the investor who is used to seeing a certain valuation of the stock, a seemingly “cheap” price becomes interesting. However, it becomes a value trap to the investor if no material improvements are made in the company’s competitive stance, its ability to innovate, its ability to contain costs, and management by the executives.
As with any investment decision, thorough research and evaluation is recommended before investing in any company that appears cheap on the basis of conventional valuation metrics.
Is it a Value Trap?
An industrial company whose stock has been trading at 10x earnings for the past six months, compared to its trailing 5-year average of 15x.
A media company whose valuation has ranged from 6x-8x EV/EBITDA for the past 12 months, compared to its trailing 10-year average of 12x.
A European bank whose valuation has been below 0.75x price-to-book for the past two years, compared to a 8-year average of 1.20x.