The Motley Fool

Is that share a value trap?

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

New British One Pound Sterling Coin Chart Rate.
Image source: Getty Images

When learning about investing, some lessons are harder than others. Putting hard-earned money into what seems like a promising investment only to see it disappear is a painful experience even very experienced investors suffer.

That is one reason diversification is so important as a risk management strategy. One big risk investors face is what is known as a ‘value trap’. Here I explain what it is, and the value trap indicators to look out for.

One Killer Stock For The Cybersecurity Surge

Cybersecurity is surging, with experts predicting that the cybersecurity market will reach US$366 billion by 2028more than double what it is today!

And with that kind of growth, this North American company stands to be the biggest winner.

Because their patented “self-repairing” technology is changing the cybersecurity landscape as we know it…

We think it has the potential to become the next famous tech success story. In fact, we think it could become as big… or even BIGGER than Shopify.

Click here to see how you can uncover the name of this North American stock that’s taking over Silicon Valley, one device at a time…

What a value trap is

We’ve all been tempted by value traps in life. The thing that’s to0 cheap to be true – a holiday, a second-hand car, a doer-upper flat. What looks like a bargain turns out to be anything but. The same applies to shares. A value trap is a share that looks surprisingly cheap, but actually is not cheap at all.

Imagine, for example, a company that is heavily reliant on one source of income, such as a medical patent or a particular client. Looking at their earnings for recent years, the shares look cheap. But if it turns out that the future earnings are greatly reduced — the patent expires, the client goes under — then the shares aren’t cheap at all.

That’s why it is important to look at a company’s likely future earnings, not just its past record. As well as earnings, I like to look at free cash flow – the money coming in the door. That is a better indication of whether a company is genuinely profitable.

Sectoral shifts can be value trap indicators

A change in a business marketplace can create value traps. For example, the high street is changing rapidly. I think retailers like B&M are adapting to this and can thrive. But a company like Card Factory faces not only a changing high street, but also shifts in consumer card sending patterns. A single digit price-to-earnings ratio is one potential indicator of a value trap – and Card Factory has that. Five years from now, we could be looking back at Card Factory’s share price today as a great bargain for a well-run business. But equally, we could be looking back wondering why people still believed in the investment case when card shops look like a declining business.

Other value trap indicators can include very high yields, a preference for unusual accounting metrics, and high net debt. But none of these is necessarily conclusive. Some companies that look like value traps are in fact great bargains. As the market has marked their chances lower, the share price has tumbled. So they can present a real bargain.

Just looking back at lows from last year, it’s incredible that some shares were as cheap as they were. Similarly, while Card Factory faces a challenging retail environment, it is a proven operator and has been able to adapt its offering, growing sales on its website for most of last year by 137%. Greeting card companies are in vogue, as the listing of Moonpig demonstrated. If Card Factory survives and thrives, today’s share price could be a bargain.

That’s why I find it worth investigating more about an apparent bargain. Some clear value trap indicators scare me off. But sometimes, a share can look like good value, not a value trap.

The high-calibre small-cap stock flying under the City’s radar

Adventurous investors like you won’t want to miss out on what could be a truly astonishing opportunity…

You see, over the past three years, this AIM-listed company has been quietly powering ahead… rewarding its shareholders with generous share price growth thanks to a carefully orchestrated ‘buy and build’ strategy.

And with a first-class management team at the helm, a proven, well-executed business model, plus market-leading positions in high-margin, niche products… our analysts believe there’s still plenty more potential growth in the pipeline.

Here’s your chance to discover exactly what has got our Motley Fool UK investment team all hot-under-the-collar about this tiny £350+ million enterprise… inside a specially prepared free investment report.

But here’s the really exciting part… right now, we believe many UK investors have quite simply never heard of this company before!

Click here to claim your copy of this special investment report — and we’ll tell you the name of this Top Small-Cap Stock… free of charge!

christopherruane has no position in any of the shares mentioned. The Motley Fool UK has recommended B&M European Value and Card Factory. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

Our 6 'Best Buys Now' Shares

Renowned stock-picker Mark Rogers and his analyst team at The Motley Fool UK have named 6 shares that they believe UK investors should consider buying NOW.

So if you’re looking for more stock ideas to try and best position your portfolio today, then it might be a good day for you. Because we're offering a full 33% off your first year of membership to our flagship share-tipping service, backed by our 'no quibbles' 30-day subscription fee refund guarantee.

Simply click below to discover how you can take advantage of this.