Today we’re going to answer the following question: what is a value trap?
A value trap is a company that is trading at very low valuation multiples versus its peers, but is trading at low multiples due to negative fundamentals and/or outlook for the company.
Value Traps are generally uncovered by a value investor who is trying to find potentially undervalued companies. This can be done by comparing a broad list of comparable companies within an industry. In doing so, one may come across a company that is currently valued well below comparable metrics. This could be a price to earnings ratio, price to book ratio, or any other valuation multiple.
Examples of Value Traps
A company could be considered a value trap if it is trading at a price/earnings ratio of 6 while its peers are trading near 10. But the reason this company is trading at such a lower multiple is because it recently just lost a major lawsuit and will be paying out millions of dollars in settlements over the next several years. This will erode future earnings potential.
This, however, is not reflected when basing multiples on current and/or trailing twelve month financials.
How can a Value Trap be spotted?
Anytime you are doing your due diligence on a company and its multiples seem too good to be true, there’s a good chance they are. Make sure to check recent news releases from the company as well as an Form 8-Ks filed with the SEC here: https://www.sec.gov/edgar/searchedgar/companysearch.
You should also check major news outlets for recent news stories that may have come to light. This could be fraudulent activity at a company, or a pharmaceutical drug that was just denied by a regulatory body.
Bottom Line
Value Traps are hard to spot, but identifying a value trap is critical as an investor. A Value Trap can sink an investor, but a true undervalued company can be extremely fruitful!