What is a value trap?

If you are a value investor, you are looking for cheap stocks. This mean that every stock you look at is either a bargain or a value trap.

How do you tell which is which? You would have thought that with so much interest in value traps, this would be a forgone answer.

Let me share the results of a survey I did by searching for the phrase “value traps” and classifying the results of the top 100 sites based on Google page rank. Refer to the chart at the bottom.

Of course comparing current price to historical price is the wrong definition. The correct way is to compare current price to intrinsic value.

If you are a value investor, you would be investing when the price is at a significant discount to intrinsic value. The question is whether your assessment of intrinsic value is accurate

If your valuation is wrong, then the stocks are really cheap for a reason and you have a value trap

But if your assessment of intrinsic value is correct, then you have a bargain

From the above perspective, value traps and bargains are two sides of the value investing coin.

So how can you avoid a value trap? You need a good analysis so that we you say that is company is sound or is able to turn around, you are correct.

Secondly you need a good valuation approach so that when you find that the stock price is lower than the intrinsic value, your estimate of the intrinsic value is correct.

If you want further insights into this question go to https://www.i4value.asia/2020/06/an-effective-w...