Is that share a value trap?

Learn how I look out for these value trap indicators to help me avoid tempting but bad investments.

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.

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

sdf

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.

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.


Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

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.

More on Investing Articles

Portrait of elderly man wearing white denim shirt and glasses looking up with hand on chin. Thoughtful senior entrepreneur, studio shot against grey background.
Investing Articles

Low P/E ratios, yields up to 9%! Are these the FTSE 250’s best value stocks?

These FTSE 250 shares offer exceptional all-round value on paper. But are they too good to be true for investors…

Read more »

Young mixed-race woman jumping for joy in a park with confetti falling around her
Investing Articles

Here’s how a 39-year-old could aim for a million by retirement, by spending £900 a month on UK shares

Our writer digs into the theory and practicalities of buying high-quality UK shares regularly to aim to retire as a…

Read more »

Businessman with tablet, waiting at the train station platform
Investing Articles

See how much a 50-year-old should invest to get a £1k monthly passive income at 65

Even at 50, there's still time to build a big enough stocks portfolio to generate a serious passive income at…

Read more »

Hand of person putting wood cube block with word VALUE on wooden table
Investing Articles

With P/E ratios below 7, are these undervalued FTSE shares bargains — or value traps?

Low valuations aren’t always the bargains they seem. Mark Hartley takes a closer look at two FTSE shares trading at…

Read more »

Warren Buffett at a Berkshire Hathaway AGM
Investing Articles

3 simple strategies that can help drive success in the stock market on a small budget

Christopher Ruane runs through a trio of strategic moves he reckons can help an investor as they aim to build…

Read more »

British union jack flag and Parliament house at city of Westminster in the background
Investing Articles

2 growth stocks backed by this British fund that’s soared 77.8% in just 3 years!

Our writer likes the look of this under-the-radar fund, especially with a pair of exciting growth stocks near the top…

Read more »

Shot of an young mixed-race woman using her cellphone while out cycling through the city
Investing Articles

Is there value in Baltic Classifieds — a soaring growth stock that brokers are buying?

Baltic Classifieds has surged after broker upgrades. Mark Hartley asks whether this FTSE 250 stock is really worth buying now.

Read more »

Close-up image depicting a woman in her 70s taking British bank notes from her colourful leather wallet.
Investing Articles

£20k in an ISA? Here’s how it could be used to target £423 of passive income each month

Earning money from dividends in an ISA is one way to set up passive income streams. Our writer explains how…

Read more »