What Is a Value Trap?

A value trap is a stock that deceives investors into believing they're buying a low cost winner. The stock may have low valuations relating to essential metrics such as the price-to-earnings (p/e) ratio, price to book value ratio, and price to cash flow ratio.

It may also have a low price and pay an attractivꦫe dividend. However, a value trap ends up failing to perform as hoped, and sometimes even dropping in value.

Investors can fall prey to so-called value traps when they go hunting for a bargain stock. These seeming bargains may appear promising, but in reality they can be losers🐼.

In this article, we'll show you how to determine if an attractive stock could be a value trap.

Low Multiples

There can be good reason why companies have low multiples of earnings, 澳洲幸运5官方开奖结果体彩网:cash flow, or 澳洲幸运5官方开奖结果体彩网:book value for an extended period of time. They may have little promise for🦩 growth in value and possibly, no future.

This can be reflected in their stock price. But some investors may think they've found a bargain stock.

A terrific example of this type of value trap 💦is Rag Shops Inc., a now-defunct company that 🎀sold fabric and craft supplies. For years that company traded under or at book value and looked cheap by several measures. Its stock hardly ever budged, causing investor confusion.

The reasons for this stock's deadlock were:

1. The company had difficulty generating meaningful and consistent profits and was unlikely to generate institutional or substantial retail interest.
2. Management was reluctant to get out on the road and tell the company's story to retail and institutional investors.
3. Competition from other craft outlets, including Michael's (and the company it would go on to acquire, A.C. Moore), was extremely stiff and the company was unable to differentiate itself.

Eventually, the company was purchased by an affiliate of Sun Capital Partners in a $9.2 million deal. Rag Shops ultimately filed for 澳洲幸运5官方开奖结果体彩网:bankruptcy, and investors who were lured in by its once low 澳洲幸运5官方开奖结果体彩网:price-to-book multiple ended up with nothing more than a loss for tax purposes.

Investors: Examine a Company's Financial Information

Investors must look beyond low valuations and a low stock price, even if those might signify a potentially winning stock pick. Dig into a company's financials to see if there are sensible reasons why these factors may exist. Determine whether those reasons mean you should temper your excitement and avoid the company's stock.

Lack of Catalysts

Product and Income News

Companies and stocks need 澳洲幸运5官方开奖结果体彩网:catalysts—exciting news or ✅events—in order to attract investor attention and advance. If a company has no new products on the horizon or doesn't expect to show earnings growth or momentum of some kind, 🐻consider avoiding it.

Historical Performance

A company's history should never be overlooked, and investors should view it in light of the company's latest financial statements.

💧 If the company cannot improve upon its position operationally, it may have trouble outpacing its competitors. Ultimately, the compa﷽ny also may have trouble garnering interest from the investor community.

Many seasoned investors and 澳洲幸运5官方开奖结果体彩网:sell-side analysts wait until a catalyst gets ready to ꦓhit the market and buy o༒r recommend the stock then. Once the catalysts evaporate or transpire they will jettison the stock.

Investors: Determine What Can Move Stock Price

Take into account any catalysts to determine if any news item could move your bargain stock's price upward. Examine the company's historical financial performance to form an idea of its financial health and operational capability. Those two factors, along with other information, can help you decide whether this is a stock to buy or a value trap.

Multiple Kinds of Shares

Some companies, like 澳洲幸运5官方开奖结果体彩网:Berkshire Hathaway, have 澳洲幸运5官方开奖结果体彩网:Class A shares and 澳洲幸运5官方开奖结果体彩网:Class B shares. The difference between the two classeܫs of stock depends on the situation.

Class B shares may contain super (or, advanced) voting rights. For example, one vote of Class B shares might be the equivalent of the votes of five Class A shares. Class B shares may also contain a 澳洲幸运5官方开奖结果体彩网:special dividend or other special rights not granted to the ave🍌💮rage common shareholder.

Investors: Consider Different Stock Classes

The average investor should be wary of investing in a company with two classes of stock. The reason for this is that the owners of the Class B shares generally are insiders or large investors and the company tends to focus on keepꦆing those investors happy rather than paying attention to the common stockholder.

Small Floats

There are many objectives that a company or stock must meet in order for the average institution to take a position in ♊it.

Many funds won't take a position in a company unless its stock trades for $10 a share or more. Fund managers and analysts may also be forbidden from getting involved in companies whose annual sales total less than $1 billion or that are unprofitable.

Usually, there are other prerequisites as well for institutional participation, and they often involve a company's float. Float in this instance refers to the number of company shares available for purchase by the public. It's calculated by subtracting the number of restricted 🌺shares from the number of outstanding shares.

Companies with a small float are unlikely to garner institutional attention because those investors will have trouble acquiring and ultimately dis💞posing of large quantities of stock. Small float can mean an illiquid stock—and a volatile price.

𝄹 When institutions decide not to buy and sell a stock, and consequently, display no interest in it, the share price can languish. By extension, the stock may become a value trap.

Investors: Keep an Eye on Float

To avoid this value trap, investors should take float into account when doing their research prior to investing. They can find information on a company's shares outstanding versus its restricted stock shares in the annual or quarterly report.

By some measures, 10 to 20 million shares is considered a small float. Be sure to compare a company's float to other companies in the same industry, or to an industry average.

Tightly Held Companies

It is usually a positive sign when insiders at a company own large chunks of their company's stock, as it can give those insiders ample incentive to find ways to enhance shareholder value.

Many institutions and entities that can move stocks (e.g., mutual funds and hedge funds) will usually not get involved in a company if it has a high percentage of insider ownersꦯhip.

If insiders own a high percentage of the shares, the investing institution may not be able to influence the board of directors or have a say in corporate governance issues. This lack of institutional interest could detract from a stock's value potential.

Investors: Examine Ownership

Investors can research the ownership percentages of company insiders. You can also learn which institutions are investors. Institutional ownership is a good sign that a low-priced stock of interest to you isn't a value trap.

The Bottom Line

At first💧 glance, a company may seem to be an attractive investmen﷽t candidate because of a low share price and low multiples.

However, unless it has catalysts on the horizon, solid financial performance history, interested institutional inves꧋tors, insider incentives, and ample float, the stock could lead you into a value trap.