I must confess that I have no idea where the term “value trap” originated. But the description is not only widely used but also widely abused by many pundits. Perhaps it was coined by some disgruntled equity analyst who managed to identify a stock that was trading below some commonly-used valuation metrics. The popular ones include the price-to-earnings ratio, price-to-book ratio, and price-to-free cash flow. But instead of seeing the share price rise to reflect the true value of the business, the price remained stuck where it was, thereby entrapping the investor at the lowly valuation.
But is that necessarily a trap? It could be unless we appreciate the finer points of value investing. This discipline believes that a share that is trading below its true value is inherently unstable. Something must give. The share price could rise, which would reward a fortunate investor who spotted the bargain with a healthy gain....