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Differentiating undervalued stocks from value traps

Thiveyen Kathirrasan
Thiveyen Kathirrasan8/26/2021 10:46 PM GMT+08  • 4 min read
Differentiating undervalued stocks from value traps
Value traps are often characterised by their low prices and cheap valuation multiples for extended periods of time.
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Last week, The Edge Singapore (Issue 998, Aug 23) wrote on why seemingly undervalued stocks do not appreciate in price. To recap, one of the ways to differentiate value traps from value plays is to look at the company’s ROE and compare it to the company’s cost of capital, based on its P/B valuation. With an attractive P/E or P/B multiple, companies which have their ROE higher or close to their weighted average cost of capital or cost of equity are more likely to be undervalued. We narrowed down 20 real estate-related companies to illustrate this concept and it is important for investors to note that this is just one way to separate undervalued companies from value traps while taking into account the company’s own idiosyncrasies.

Value traps are often characterised by their low prices and cheap valuation multiples for extended periods of time. If we can gauge the historical performance of the company against the share price movement, it should be able to provide some colour on whether the company is truly undervalued or is a value trap. In other words, comparing the historical fundamental or value growth against the price growth will indicate that a company is undervalued — if its value growth is more than its price growth. This difference or divergence between value growth and price growth could be what causes the stock to be undervalued or overvalued — or sometimes even fairly valued.

To simplify things, we can break down the value or fundamentals of the company into four components — revenue, net income, operating cash flow and free cash flow — in order of increasing importance. We will reuse the table from last week containing the same 20 real estate-themed stocks to assess whether these companies are potentially undervalued or value traps. We will arbitrarily use a one-year, three-year, five-year and 10-year period to compare each company’s value growth against its price growth. A 10%, 20%, 30% and 40% weightage for revenue, net income, operating cash flow and free cash flow respectively will be used to represent each company’s value growth.

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