Value Trap

What Is a Value Trap?

A value trap is a stock or other investment that appears to be cheaply priced because it has been trading at low valuation metrics, for example, multiples in terms of price to earnings (P/E), price to cash flow (P/CF), or price to book value (P/B) for a significant time frame period. A value trap can draw in investors who are searching for a bargain because they seem inexpensive relative to historical valuation multiples of the stock or relative to those of industry peers or the prevailing market multiple. The danger of a value trap presents itself when the stock continues to mull or drop further after an investor buys into the company.

Understanding Value Traps

Generally, a company that has been trading at low multiples of earnings, cash flow, or book value for an extended period of time has little promise, and possibly no future — even assuming that the price of their stock appears attractive. A stock becomes a value trap to an investor in the event that no material improvements are made in the company's competitive stance, in its ability to innovate, in its ability to contain costs, or potentially in its executive management.

Even on the off chance that a company has been successful in prior years — having experienced rising profits and a healthy share price — it can fall into a circumstance where it is unable to generate revenue and profit growth due to shifts in competitive dynamics, a lack of new products or services, rising production and operating costs, or ineffective management.

For a used to seeing a certain investor valuation of this company's stock, a price that appears cheap can be appealing. Value investors are particularly susceptible to value traps. Likewise with any investment decision, exhaustive research and evaluation is recommended before investing in any company that appears cheap on the basis of conventional valuation metrics.

Identifying Value Traps

Identifying value traps can be interesting, but a careful fundamental analysis of the stock can reveal what is a trap and what is a wise investment opportunity. Here are some examples of possible value traps:

• 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.
• An 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.

Features

• A value trap is a poor investment because the reason at the low cost and low multiples is the company is experiencing financial instability and has little growth potential.
• Value traps are investments that are trading at such low levels and present as buying opportunities for investors but are really misleading.
• For a value trap investment, the low price is often accompanied by extended periods of low multiples too.