What is a value trap?

Learn how value trap shares may appear undervalued but ultimately fail to provide the returns that investors seek.

Investor trying to lasso a pile of coins across a cliff, indicatin a value trap scenario

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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. Value traps 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?

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." Value investors 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 handsomely. Using 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' Investors 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. Discount models look at the projected future cash flows or dividends from a company and discount these to arrive at a present value. Metrics 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. Value trap 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

Value trap 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.

This article contains general educational content only and does not take into account your personal financial situation. Before investing, your individual circumstances should be considered, and you may need to seek independent financial advice.

To the best of our knowledge, all information in this article is accurate as of time of posting. In our educational articles, a 'top share' is always defined by the largest market cap at the time of last update. On this page, neither the author nor The Motley Fool have chosen a 'top share' by personal opinion.

As always, remember that when investing, the value of your investment may rise or fall, and your capital is at risk.

This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.