At first glance,BHP Billiton(LSE: BLT) looks to begreatvalue. The companys shares currently trade at a six-year low, support a dividend yield of 6.9% and trade at a historic P/E of 6.2. These metrics make BHP one of the cheapest large-cap stocks in developed markets.
However, while BHP looks cheap at first glance, the company has all the hallmarks of a value trap.
Value trap
Value traps are difficult to spot. Finding them isnt an exact science, and investors often get sucked into them when searching for bargains.
Nevertheless, there are three key traits most value traps have in common and by avoiding companies that display these traits, you can increase your chances of avoiding these traps.
Secular decline
The first common characteristic of value trapsis that of secular decline. More specifically, investors need to ask if the company in questions share price is falling due to cyclical factors, or the companys business model is under threat.
For example, newspaper publishers such as Trinity Mirror have seen revenues slide over the past decade due to the secular decline of newspaper circulation and print advertising.
However, with BHP its pretty easy to see that the company is coming under pressure from cyclical factors. The commodity bubble has burst, and BHPs earnings are set to fall as a result. But as the market rebalances over the next few years, commodity prices should recover.
So, BHP passes the first value trap test.
Destroying value
The second most common trait of value traps is the destruction of value. In other words, investors need to ask if the companys management destroyed shareholder value by overpaying for acquisitions and misallocating capital?
Unfortunately, it looks as if BHPs management is guilty of capital misallocation. The companys decision to enter the shale oil market has so far cost the group billions.
BHP expanded into US shale in 2011, spending nearly $17 billion to acquire Fayetteville assets from Chesapeake and taking over Petrohawk Energy. But according to figures published at the end of last year, BHPs Fayetteville assets, acquired for $4.8bn, are now worth only $2.1bn, and Petrohawks assets have been written down by $2bn. Further, despite spending nearly $2bn per annum to develop these hydrocarbon assets, management doesnt expect the division to be free cash flow positive until 2016.
Cost of capital
The third and final most common trait of value traps is a low return on capital invested. Put simply, if a company continuously earns a lower return on invested capital (equity and debt invested in the business) than the groups cost of capital (debt interest costs), it deserves to trade below book value.
According to my figures, which are based on BHPs financial reports, over the past twelve months the company has earned a return on invested capital of 11.5%. However, the groups cost of capital has risen to a staggering 27%.Based on these figures the company deserves to trade below book value as it is destroyingvalue for shareholders. Overall, BHP looks like a value trap to me.
But don’t just take my word for it.I strongly recommend that you do your own research before making a trading decision — you may come to a different conclusion.
To help you assess BHP for yourself, our top analysts have put togetherthis new report entitled,“How YouCould Retire Seriously Rich“.
This is a new report from The Motley Foolthattakes you throughthe seven essential steps you need to take to become a stock market millionaire.
What’s more,thereport fromexplainshow spending just 20 minutes a month could help you create a portfolio that could bring you closer to financial freedomfor life.
Click hereto check out the report–it’s completely free and comeswith nofurther obligation.
Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.