Value Trap

How Does a Value Trap Work?

Value traps are securities that currently trading at low valuation multiples, creating the misleading illusion of being an attractive buying opportunity to investors.

A value trap is a stock that appears to be cheaply valued after the company’s valuation multiples, such as its price to earnings ratio (P/E) or enterprise value to EBITDA (EV/EBITDA), has fallen substantially relative to historical trading levels.

While the market can be (and often is) inefficient at pricing the share issuances of publicly-traded companies, a steep decline in the equity value, or market capitalization (and thus, market value per share) can potentially be a “buy” signal to investors.

Simply put, the knee-jerk reaction that a stock which has fallen out of favor with the market is mispriced and currently undervalued illustrates the value trap concept.

In particular, a stock that has incurred a substantial drop-off in value can be attractive to value investors, who actively seek to purchase undervalued securities trading below their intrinsic value.

• Intrinsic Value > Market Value ➝ Undervalued (“Buy”)
• Intrinsic Value < Market Value ➝ Overvalued (“Sell”)
• Intrinsic Value = Market Value ➝ Undervalued (“Neutral”)

What is Value Trap Indicator?

From the perspective of a value investor, the market reaction and sell-off could have been overdone (“overreaction”), creating an opportunity to purchase a stock at a discount.

In short, a value trap indicator is a market sell-off, where the stock price of a company now trades far below historical levels.

Once the market “corrects” itself and the share price normalizes, the value investor reaps the reward from identifying an undervalued stock and benefiting from the increase in share price, i.e. the stock market participants often exhibit herd-like behavior, which settles down once the dust settles (and share price rises to actual intrinsic value of the stock).

The issue, however, is that a company seldom falls out of favor with the market without a valid reason. In other words, the recent stock price decline could be justified and stem from underlying problems pertaining to the fundamental factors that impact the share price.

Therefore, the stock trades at low multiples, which can give off the impression that it is trading at an attractive bargain, when in reality, the “cheap” price is often warranted due to issues with the company’s fundamentals (e.g. less revenue growth, profitability, and cash flow), unfavorable market conditions, headwinds that present material risks to the business, and a bleak outlook on the operating performance going-forward.

The decision to invest in a company’s stock for the sole reason that its shares are trading at a low multiple post-sell off could turn out to be profitable. Or, the sell-off could be a potential value trap that causes the investor to incur a substantial loss on the investment (i.e. “falling knife”).

How to Avoid Falling for a Value Trap

In order to avoid falling for a value trap—a common fallacy and mistake made by value investors—to focus must shift toward the fundamentals of the company.

An objective analysis on the fundamentals of the company must be performed to determine if the decline in stock price is warranted, or if the market is “wrong”.

In the latter scenario, the value investor will benefit monetarily once the share price recovers and starts to reflect the intrinsic value of the company.

Since a company’s intrinsic value is a discretionary figure—i.e. different based on the judgment of each investor)—the actual market price and market value per share derived from a valuation analysis, like a discounted cash flow (DCF) or comps analysis (e.g. trading comps and transaction comps), can often deviate from one another. Hence, the core question here is, “Is the market right?”

The key to avoid falling for a value trap is to analyze the totality of a company’s financial health, competitive advantages, and future prospects, rather than deciding to buy shares in a company based on notion that a valuation metric, like the price to earnings (P/E ratio), has dropped significantly relative to historical trading levels.

By remaining disciplined to the investment strategy, conducting an in-depth due diligence process (i.e. objective analysis), and proactively trying to understand the underlying reason for the decrease in stock price (“red flags”), investors can improve the odds of sidestepping value traps, and not incurring a monetary loss.

However, even the top institutional investors occasionally get caught, so portfolio diversification and other strategies to mitigate risk are necessary, per usual.

The core drivers that underpin the valuation of a company must be measured to form a holistic view on the its stock price, rather than arriving at the simplistic conclusion that a stock price decline equates to an attractive investment opportunity.

By conducting an in-depth analysis on the company and its fundamentals, an investor can determine whether the market is “right” or “wrong”, which to reiterate, is a discretionary decision.

The most common financial ratios used to analyze the fundamentals of a company are as follows:

What are the Risks of Value Traps?

Value investors who seek to buy stocks trading below intrinsic value are in particular susceptible to value traps.

The main risk attributable to falling for a value trap is, of course, incurring a monetary loss on an investment and selling the security at a price lower than the purchase price.

For instance, the stock price of the “undervalued” company could continue to decline—or perhaps even enter a “free fall”—after the initial purchase, leading to the incurrence of substantial losses (and thus, a lower return).

In the absolute worst-case scenario, the underlying company could default on its debt obligations and become insolvent, which presents the risk of the issuer filing for bankruptcy, making the stock worthless (and shareholders rarely recover their original investment—i.e. “made-whole”—in Chapter 11).

Not to mention, the opportunity cost of holding a value trap must be considered, where the investor could have allocated capital toward more profitable investments and identifying true bargains (i.e. intrinsic value > market value per share).

However, mitigating the risk of a value trap is practically impossible, considering the risk is inherent to all aspects of investing—irrespective of the strategy—so, portfolio diversification and investing only if there is a sufficient margin of safety are critical to reduce potential losses, among other methods.

Furthermore, a value investor must form a thesis on the management team and their plan to create shareholder value, which requires understanding the company’s history and past strategic initiatives (and the corresponding outcome).

In closing, to minimize the risk of falling into value traps, value investors must go beyond surface-level valuation ratios and analyze the overall financial health and prospects of a company on a granular basis.