Investors often use valuation metrics to screen for “cheap” or “undervalued” companies. Identified correctly, undervalued companies will provide better returns than the broader market.
However, we can often fall into the trap of believing a company is cheap if we are overly reliant on using common valuation metrics that may be misinterpreted.
Since I started investing, I have come across numerous value traps and thought it would be useful to put together a short list of common value traps to be avoided.
Low earnings multiple but unstable earnings
This is probably the most obvious value trap. A company that trades at a low earnings multiple – i.e. a company with a market capitalisation that is relatively low compared to its past earnings – may look cheap. But if its earnings are not sustainable, it may become a really bad investment.
Moderna and BioNTech both had massive earnings boosts from selling COVID vaccines in 2021 and 2022. But both have also seen their earnings plummet since. Investors who looked at their historical earnings multiples during the COVID-boom may get the idea that they were cheap, but the COVID-induced profits were not likely to be repeated.
Looking at a company’s historical earnings can give investors some idea of its profitability. But the past does not always mirror the future and investors need to think about a company’s future earnings too.
High but unsustainable dividend yield
A company with a high trailing-twelve-month dividend yield can seem enticing. But it could still end up as a value trap if its dividend is not sustainable. What makes a dividend sustainable? Some good questions to ask include:
- Is the dividend supported by a regular profit stream?
- Is the dividend a one-off special dividend that will not recur?
- Is the dividend payout ratio above 100%?
- Does the company have a predictable and recurring revenue stream?
All of these questions help us to identify if a company is a sustainable dividend payer or simply a dividend value trap.
Lots of cash, but with a cash-burning business
Investors may get attracted to a company that has lots of cash on the balance sheet. The company is even more enticing if its net cash positive is a large percentage of its market capitalisation. But the balance sheet is not an indicator of the quality of a business.
A company with a lot of cash on the balance sheet can still end up as a value trap if it has a weak business that constantly burns cash. For instance, there are numerous biotech companies in the US stock market that look promising with high net cash balances but that are burning lots of cash to research potential drugs. Although some of these biotechs may end up getting FDA approval for their drugs and become winners, a vast majority of them will end up with unfeasible drugs and a cash balance that has been wiped out after years of unfruitful research.
A management that won’t return cash to shareholders
What’s a company with lots of cash on the balance sheet, a stable and profitable business, trades at low earnings multiple, but management refuses to return cash to shareholders? It is a potential value trap.
There is no point in having a stable and recurring business generating lots of cash but shareholders will never see that cash. This is a common situation in companies listed in Singapore and Japan, where corporations retain too much cash on the balance sheet.
This phenomenon may happen because a company is majority family-owned and the family does not need the cash as dividends. Or the management team may be ultra-conservative and retain cash unnecessarily. Either way, shareholders are left with nothing or have to wait decades to see their cash.
Final word
It does not make sense to invest in a company at a price that’s significantly higher than its intrinsic value. But just searching for companies with low valuation metrics does not mean you will end up with bargains. It pays to recognise the existence of value traps.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently do not have a vested interest in any stocks mentioned. Holdings are subject to change at any time.
Would you consider Haw Par Corporation to be a value trap given that it has tons of cash but management has been unwilling to distribute to shareholders despite multiple shareholders raising the same issue at multiple AGMs?
Hi Mark,
I think Haw Par Corp is an example of a company that retains too much cash on the balance sheet. It does provide some dividends but the payout ratio seems very low and they are not using the cash proactively. Just looking back the past few years, the dividend paid out each year is even less than the dividend it collected from its UOB stake.
Unless management changes its capital allocation strategy or dividend policy, I don’t think it is likely that the company will trade close to its book value.