A value stock is a company that has an attractive valuation relative to the rest of the market as measured by price/earnings, dividend yield, book value and other factors. The term is often applied to companies with a low growth rate to contrast them with the relatively higher valuations that are often awarded to companies that are growing. A value trap is a stock that has an unusually attractive valuation because the investment is steeped in special risks that aren't necessarily reflected in its financial metrics. The following are examples of situations that can make a stock look like a value when it is in fact a value trap.
DebtIn many cases, a firm with an extremely high debt load has an attractive price-to-earnings multiple. Such firms may be at high risk of bankruptcy or requirements to sell assets at a loss to make debt payments.
Hostile ManagementFirms that have a history of making decisions that benefit its executives over the interests of shareholders. Excessive compensation, insider trades, lavish expense structures, cronyism and other factors can mean that a firm that looks profitable may be unlikely to pay investors in the long run.
Business ModelA firm with a fundamentally flawed business model. For example, a growth company that increases its expenses at a faster rate than revenue may not have a scalable business model.
RiskA firm that is taking excessive risks may look profitable for a few quarters and then suddenly implode. As a simple example, a company that only has a few customers represents a concentration risk.
Business CyclesBusiness cycles are periods of boom and bust that affect certain industries and the global economy as a whole. For example, an increase in the price of a commodity may trigger a wave of capital investment to produce more. When the new capacity hits the market, the price may decline dramatically resulting in bankruptcies across an industry. In many cases, stock prices will decline in an industry when analysts start to get the feeling a bust is ahead. As such, affected firms may look like an extreme value just as the bust begins.
|Definition||A stock that has an attractive valuation relative to the rest of the market.||A stock that appears to have an attractive valuation because of risks that may not be obvious. Value traps are often over valued because investors who focus on measures such as price/earnings and yield drive up the price without proper consideration of risk factors.|
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