When 'value' is a value trap
A value trap
is a company that trades cheaply for its valuation metrics
, appearing to represent good value. Investors, however, should beware as there may be a reason why the share is trading at a low price.
can trade at low multiples for extended periods, failing to perform as investors expect. Although these shares initially present as undervalued and attractive buying opportunities, their returns ultimately fall short of expectations.
To better understand a value trap, let's take a closer look at the overall value investing strategy
What is value investing?
involves buying shares that appear to be trading at less than their intrinsic or book value
Warren Buffett is a famous value investor
, seeking out shares at prices he considers unjustifiably low. As Buffett says, "Price is what you pay. Value is what you get."
look for shares that they think the broader market is underestimating. Over time, they expect the market will realise the intrinsic worth of the shares and bid them up, rewarding the investor
sing this investment strategy, they seek out shares for their portfolio that are 'on sale'. For example, bad news from a company may result in a fall in its share price
that is not justified by the long-term outlook. Also, the market may enter a downturn, but the drop in a particular share price
might be too great given the company's fundamentals
, so it becomes a 'value buy'
do the work to determine which shares are 'undervalued' and buy them at a discount
to their fundamental or 'intrinsic' value. There are a number of financial metrics value investors
use to do this. These include the price-to-earnings (P/E) ratio
, the price-to-book or P/B ratio
, and the level of free cash flow
What is the intrinsic value of a company?
The intrinsic value of a company is its fundamental, objective value. Various methodologies can be used to determine this, including discounted cash flow (DCF)
models, the dividend discount
model, and the use of metrics
such as the P/E ratio
models look at the projected future cash flows
from a company and discount
these to arrive at a present value.
such as the P/E ratio
can be used to make a comparison between similar companies. Where these models and metrics
reveal the price of a share is below its intrinsic value, the value investor
sees a potential investment opportunity.
What is a value trap?
This is where it gets tricky. Value traps
are companies that appear to be undervalued but ultimately fail to provide the return that investors seek. They may have a low P/E ratio
or cash flow
multiple compared to their peers. This makes them attractive to investors
at first glance.
shares, however, may be trading cheaply for a reason. These may include financial instability, low growth potential, or small floats. A company trading on low multiples may be operating in a dying industry, failing to grow customer numbers and revenue, or facing intense competition.
How to avoid value traps
shares often trade on attractive metrics
, so they appear cheaply priced in comparison to their peers. Sometimes, however, there are reasons why this is the case.
To generate meaningful (and growing) profits, companies need to advance. This might be through the release of new products
or services, participation in a growing industry, or improvements to existing technologies. If a company is failing to demonstrate momentum, it may not be such a promising investment option for your share portfolio.
Other factors that can contribute to a lack of share price
performance include small floats and tightly-held companies. This is where institutional investors have certain parameters that shares must meet before they invest. Companies with a small number of shares trading may not meet these parameters, thus fail to attract institutional attention.
Without institutional investors, share prices may fail to take off, resulting in a value trap.
Tightly-held companies can also turn into value traps
. It can be beneficial for the founders and/or managers to hold a decent portion of shares in a company, as this incentivises them to maximise shareholder
value. If they hold too many, however, institutional investors may have a difficult time influencing the direction of the company, resulting in a lack of interest.
Whether a particular share is good value or a value trap
will depend on multiple factors. Ultimately, only time will tell if low metrics
are accurate or represent an underestimation of potential.
For value investors
, keeping an eye out for signs of value traps
may be a valuable exercise over the long term