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What is a value trap and how can you protect yourself from it?
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What is a value trap and how can you protect yourself from it?

created Forex Club15 Września 2022

Investing with fundamental analysis is not easy. This is especially true for investors who like to use multipliers to compare companies. Indicators such as:

  • price to book value (C / WK), 
  • price to profit (C / Z),
  • price to free cash flow (C / FCF),
  • economic value to EBITDA (EV / EBITDA).

Of course, these types of indicators have practical uses, but of course they are not ideal. For those interested, we recommend the articles about price to profit and price to free cash flow. In today's article we will explain what it is value trap and how to protect against it. We invite you to read!

What is a value trap

Finding undervalued companies through low multipliers is very dangerous. This is because sometimes very cheap companies have problems that have already been noticed by the market. As a result, a low valuation is simply a discount that the market places on the risks that are visible in the company. A value trap is a situation in which an investor buys a "cheap" company that, despite its low valuation, "does not want" to bear the discount. As a result, the low valuation persists for many quarters or even years. Sometimes, despite the low valuation, the share price, instead of rising, steadily tends to the south. The reason is the realization of a negative scenario, which reduces the intrinsic value of the enterprise. It is worth remembering that in the long term it is an ally of high-quality companies with strong foundations, and the worst enemy of weak companies that do not create value for the owners of the company. For this reason, it is very important to distinguish between factors damaging the goodwill in the long term from factors increasing the company's intrinsic value. Thanks to this, the investor will be able to easily avoid the classic value trap.

Value trap # 1

Wrong indicator taken for analysis

This is a fundamental mistake for traders who only focus on one multiplier. However, remember that every business is different. For this reason, some indicators are worthless in the company's analysis. For example: the price-to-book ratio is useless in the case of analyzes of technology or pharmaceutical companies, the C / WK ratio is not very important. This is due to the fact that technology companies do not have too many fixed assets, because the process of producing services is completely different than in the case of manufacturing companies. In turn, pharmaceutical companies have a significant part of the book value in intangible assets, which include drug patents. For biotech companies whose future depends on a new drug. Then the value of the assets will depend on the positive progress of the potential formulation through successive drug introduction phases.

Value trap # 2

The book value is not equal to the intrinsic value of the enterprise

Of course, C / WK is one of the indicators that can be helpful for banks, REIT or companies with activities requiring very large fixed assets (factories, machines, etc.). It is worth mentioning that the book value based valuation is very sensitive to asset write-downs (e.g. inventories, receivables). For this reason, this type of analysis requires a thorough examination of the real value of the assets. The problem with proper asset valuation is especially apparent in the case of bank analysis. This was particularly evident during the subprime crisis, when the "strong balance sheets" of many banks were only solid at the book level. In fact, the quality of the assets was significantly inferior to the accounting valuations.

Another problem is that the book value itself is not the same as the intrinsic value of the company. This is because most companies are valued based on future free cash flow discounted to date. For these types of companies, the size of the book value is not very valuable. Book value is a good idea for companies that do not carry out a large operating activity and the main value is e.g. land or buildings.

Low book value may encourage investors to buy a "cheaper" company. Sometimes, however, such a low P / W ratio may mean that there is a classic value trap, when the low valuation results from the investment risk in enterprises. An interesting example is Deutsche Bank, which has had a low price-to-book ratio for many years. 

00 C_WK

Source: Ycharts.com

For many years, the largest German bank was valued at just 0,25. For comparison, the American bank JP Morgan has the above-mentioned ratio above one since 2016. Theoretically, Deutsche Bank shares are much "cheaper" than the US JP Morgan, looking only at the price-to-book ratio. However, if you look at the chart for the last 5 years, you can see that investing in a "more expensive" company brought a much better rate of return than buying shares of "cheap" Deutsche Bank.

01 JPM DBK

Source: stooq.pl

What was the reason for the "cheapness" of Deutsche Bank? One of the problems was exposure to "toxic" assets that have been a burden for the company for many years. As a result, Deutsche Bank's return on equity was much lower than that of its American competitor. Since 2017, JP Morgan usually generates a dozen or so percent return on equity (ROE). In turn, Deutsche Bank very rarely generates a positive ROE.

Value trap # 3

Low P / Z ratio = it's cheap!

The P / E ratio can be a good comparative method in a situation where the compared companies operate in the same industry and have a similar capital structure. Many investors forget that the more indebted a company is, the more risk it entails for the investment portfolio when buying shares in such a company. Some companies are so heavily indebted that the market is pricing them in at very low P / E ratios. Sometimes there are situations when a "cheap" company is in a very difficult liquidity situation and there is a risk of bankruptcy. An example was the aviation industry during the COVID-19 crisis when companies were traded on very low (historical) P / E ratios. Delta Airlines was traded in March 2020 with a price / earnings ratio of 2,9. This meant that the airline was valued at less than three times the net profits of 2019. This is also an example of a disadvantage of the price-reward ratio. Due to the fact that the standard measure is based on past performance, its low level may be a trap due to the fact that future profits will be much lower than the present ones. This was the case with aviation companies, which ended with large losses in 2020. In turn, in 2021 the profits were modest, which meant that the indicator of, for example, Delta Airlines in 2021 was around 100. 

02 pe delta air lines

Source: ycharts.com

The value trap for a low P / E ratio may be due to shrinking business. As a result, the company is valued at a considerable discount in relation to the "broad market", but this discount is due to the company's estimation of worse market prospects. An example of such a company is a company listed on the French stock exchange - Eutelsat Communication. In the fiscal year 2016/2017 (end June 2017), the company generated € 1 million in revenues and generated a net profit per share (EPS) of € 477. In May 1,512, the company traded at € 2018. This meant the price to profit at that time was 15,27. This was well below the average P / E for companies listed on the Paris Stock Exchange. In the last financial year (end June 9,90), it generated € 2021 million in revenues and achieved a net profit per share of € 1. The company is currently trading at € 234. This means the price to profit (P / E) is now 0,93.

Sometimes the very low value of the P / E ratio may result from the fact that the company's operating activity is cyclical. As a rule, the market is aware of the specifics of the company's operations by adjusting its valuation. For this reason, in a period of high returns, a "cyclical" firm is traded at a discount to the P / E multiplier relative to broad market shares. The low valuation already includes the risk of deteriorating financial results in the near future. Another reason is that profits from this industry are difficult to predict (eg, it is difficult to predict copper prices in 5 or 10 years). Cyclical companies include enterprises from the steel industry, raw materials, as well as companies from the automotive industry or capital goods.

Value trap # 4

Low C / FCF ratio = cash machine

This is a slightly different type of value trap. The company is valued low in relation to its free cash flow. This does not mean, however, that the company is a "cash machine". There are many reasons why the company is priced at a discount to the wide market. Among the most popular are:

  • A sharp increase in FCF due to a momentary positive change in working capital;
  • Capex reduction temporarily which increases FCF;
  • Large SBCs that "dilute" the profits;
  • It is a cyclical company;
  • The company operates in a declining industry.

As you can see, there are many reasons why the company has a low C / FCF ratio. It is also worth remembering that some firms should not be valued based on this indicator. This is due to the specificity of the business. For example, a bank's cash flow cannot be compared to an ordinary manufacturing or service company. For this reason, the indicator based on free cash flow should not be used in the analysis of banks. This is because the bank's business consists in collecting deposits (cash inflow and increasing costs) and granting loans (outgoing cash and increasing revenues). 

Value trap # 5

High EBITDA = high profits and FCF

EBITDA it is profit before interest, taxes, depreciation and amortization. For some analysts, this is a figure that approximates a company's potential cash flow. For this reason, some companies use the EV / EBITDA ratio (economic value / EBITDA). However, the downside to EBITDA is that it is a very poor approximation of cash flow. This is because EBITDA does not take into account changes in working capital. Sometimes changes in working capital consume most of the cash flow from operating activities. It results, for example, from the necessity to increase the stock level in the warehouse, financing recipients (receivables) or the necessity to repay suppliers (trade liabilities). EBITDA is also insensitive to the level of financial leverage and the resulting increase in interest costs. For example, there are companies with a very high ratio and a small net profit, because financial costs "eat up" almost the entire EBITDA.

How to protect yourself from the trap of values?

To avoid the value trap, the investor should only look for companies with "tempting" C / Z, C / FCF ratios that:

  • They have a lasting advantage over the competition ;;
  • They have a competent management
  • Have a high or improving ROIC (Return on Invested Capital);
  • The company increases the scale of operations (increases revenues and profits).

In order not to get caught in the trap of values, you should thoroughly understand the strengths and weaknesses of the analyzed company. Very often potential "Red flags" can be seen after reading the company's annual report. It may be helpful, among others interviews with company CEOs or senior management. In addition, it is worth browsing industry portals that will bring closer the nuances of the sector in which the analyzed company operates. 

It is also worth looking at the competitive advantages (the so-called moats) that an enterprise may have. An example of a competitive advantage is, for example, economies of scale (greater production capacity or having the largest social platform), a brand (e.g. Coca-Cola) or corporate culture (Amazon). Another example of a moat is the so-called network effect, which have, among others companies such as Visa or Mastercard. Of course, sometimes the moat is temporary (e.g. a new production method or a patent close to expiry). For this reason, it is worth checking carefully how durable the company's moat is. If a company has a lasting (or long-term) competitive advantage then a low valuation can be an investment opportunity. 

It is also worth checking what "quality" the management of the company is, because even the best company can be destroyed by incompetent management. Good management does not only focus on short-term effects, but develops the product offer and invests in projects that will bring benefits in the long term. In order to check the competences of the management board, it is worth following the career of higher management and checking how the management board of the company dealt with the problems that faced the enterprise.

You should always look at how the company invests its capital. Due to the fact that every company does not have unlimited human and capital resources, it always has to choose between the available options. It is best when the company selects projects based on, inter alia, about ROIC (Return on Invested Capital). The higher the ROIC, the more cents the company receives on the dollar invested. As a rule, high ROIC is held by companies that can efficiently allocate capital and have a very profitable operating business. The main drivers of increasing the intrinsic value of the company are the increase in revenues and improvement of ROIC.

It's also worth a look is a company with an attractive multiplier ratio increasing its scale of operations, or is it a declining business. It is best if the company has a huge potential to increase the scale of operations ahead. In such a situation, an increase in the value of the stock will not require an increase in the price-earnings multipliers or price-to-free cash flow multipliers. Of course, the increase in revenues alone is not a guarantee of increasing the intrinsic value of the enterprise. It is important that the increase in revenues generates a higher ROIC than the weighted average cost of capital.

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Forex Club
Forex Club is one of the largest and oldest Polish investment portals - forex and trading tools. It is an original project launched in 2008 and a recognizable brand focused on the currency market.