A value trap is when a stock appears to be cheap because of low valuation metrics such as the P/E ratio, cash flow, or book value. Investors buy in thinking they are getting a good deal but then the stock continues to drop even further.
A common way of avoiding value traps is by looking at profit margin. Is profit margin going up or down? What are analysts forecasting for profit margin next quarter? The idea is that a stock may look cheap on the P/E ratio but if profit margin is contracting, it’s really not cheap at all.
Another way of avoiding value traps is by looking at the forecast for EPS. If the forecast for EPS is coming down, then a stock with a low P/E multiple based on past earnings is actually much more expensive because future earnings are dropping.
A value trap is when the financial metrics (fundamentals) of a company are deteriorating along with the price. Look at those fundamental metrics in addition to the P/E ratio to minimize your odds of getting caught in a value trap.<< Back to Glossary Index