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Differentiating undervalued stocks from value traps

Goola Warden
Goola Warden8/19/2021 7:36 PM GMT+08  • 3 min read
Differentiating undervalued stocks from value traps
Undervalued stocks can be differentiated from value traps measuring their ROE versus cost of capital
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Investors have often wondered why seemingly undervalued stocks never seem to get off the ground. Hongkong Land is a prime example of this. Why can’t the stock price narrow the discount between its price and its net asset value (NAV)?

In March this year, CapitaLand’s management gave the market a partial answer. CapitaLand trades at a discount to NAV, and its management had an aim to narrow this discount. For several years, the developer — soon to be restructured — focused on ROE. The stated target was 8%. In 2018, this was raised to 10%.

At an ROE of 10%, CapitaLand would have to make net profit of around $2.3 billion, given its shareholders equity of $23 billion, give or take, and total equity of $39 billion. The higher CapitaLand’s net profit, the more capital would accrue to its shareholders equity because companies put aside retained earnings, or revenue reserves.

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