Value Investing and the Value Trap

The value investing strategy hinges on finding the stocks of fundamentally sound companies which are trading at a discount to their true or intrinsic worth. That situation can transpire for all sorts of reasons. A stock (business) can be unpopular with investors because it’s temporarily out of fashion, is going against a general market trend or it’s off the market’s radar. But they’re not the only reasons why a stock can be cheaper than it really should be: stocks can be undervalued for other and more worrying reasons.

The fundamentals

To determine if a stock is undervalued or not, value investors analyze a company’s financial fundamentals. They’ll scrutinise a range of ratios including – but not limited to – Earnings Per Share, PEG, P/E Ratio, Dividend Yield and Payout Ratio, Book Value, Price / Book, Price / Sales Ratio and Return on Equity. No matter how meticulous the analysis, sometimes some of these ratios can be misleading, one of the main culprits being Earnings Per share (EPS). EPS is widely considered to be one of the more important ratios because it shows how much of the company’s profit is apportioned to each share. But the fact is that when EPS figure increases it doesn’t always follow that the profit increasing accordingly. Although two companies may have very similar EPS, one of them may need substantially more shareholder’s capital to generate the same EPS. Out of the two, the most appealing option for the value investor would be the business requiring less capital.

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