Paramount Global (PARA, Financial) has seen its stock perform very well year-to-date with shares up 28.26%, showing momentum in a year that the U.S. stock market as a whole has sown weakness as a result of several key factors, like fears of a recession, high inflation rate and rising interest rates. However, despite the recent outperformance, I believe the future for shareholders of this iconic media and entertainment company is lackluster. Despite the rebound this year, the stock has been in a long-term decline, and so has the company's earnings, meriting a "possible value trap" warning from the GF Value chart. I'm inclined to agree with that assessment. There are several warning signs supporting this thesis, from a too-low price-book ratio to worsening fundamentals and a lack of growth.
What is a value trap?
A value trap is a term used to describe a stock that appears to be undervalued based on paper, usually based on traditional valuation metrics such as the price-earnings and price-book ratios, but which may deserve the cheap valuation due to the fact that its underlying business fundamentals are deteriorating.
To avoid falling into a value trap, it's important to conduct thorough research on a company's financial health and growth prospects before making an investment decision. This includes analyzing its management team, industry trends, competitive landscape and overall market conditions. Investors should be wary of companies that have high debt levels, declining cash flows and limited growth opportunities.
There's no sure-fire way to identify a value trap, but personally, I like to use the following criteria as a framework:
Low Valuation Metrics: The stock has low valuation metrics, such as a low price-earnings ratio, a low price-book ratio, or even an artificially inflated dividend yield due to the low price, which may make it appear undervalued.
Deteriorating Fundamentals: The company's business fundamentals, such as revenue, earnings, cash flows and market share, are deteriorating or stagnating. This is a key characteristic of a value trap because it suggests that the stock's low valuation metrics may be due to underlying problems with the company's operations or industry trends.
Limited Growth Prospects: The company may have limited growth prospects or is facing significant competition, which can hinder its ability to generate future earnings growth.
Poor Management: The company may have poor management or a history of making poor business decisions that have negatively impacted its financial performance.
External Factors: The company may be facing external factors such as regulatory changes, lawsuits, or geopolitical risks that can negatively impact its financial performance.
What makes Paramount Global a value trap?
To start off, the price-book ratio for Paramount Global as of this writing was 0.60. This is a little too cheap. The price-book ratio increased from 2009 to 2017, and then it declined to below 1.0 as of late 2021. In 2022, this ratio remained below 1.0, indicating negative investor sentiment.
Additionally, we can see the company's profitability and growth metrics are not in good shape. The operating margin has collapsed from 22.03% at the end of 2021 to 7.7% in 2022. The profitability is very weak as the net margin fell from 15.89% in 2021 to 3.66% in 2022.
The cash flow trend is also anemic. The cash flow from operating activities, which shows how much cash a company makes from its core business operations, has declined from $2.294 million in fiscal year 2020 to $953 million in fiscal year 2021 and $219 million in fiscal year 2022.
I am also not thrilled about the free cash flow trend. Free cash flow is crucial for valuation purposes and for business survival and growth. In 2021, the company reported free cash flow of $599 million, a decline of 69.59% compared to the previous year, and then in 2022 it reported free cash flow of -$139 million, meaning it was burning cash.
Some may argue that Paramount Global has shown revenue growth after the pandemic - 13.06% in 2021 and 5.49% in 2022. However, declining revenue growth is not considered positive for a company, and the quarterly revenue growth does not show a clear trend over the past four consecutive quarters, with a decline of 8.40%, followed by an increase of 6.15%, then a decline of 11.09% and lastly an increase of 17.57%. The bottom line trend leaves hardly any room to be optimistic as in the past four quarters the company reported net income of $391 million, $358 million, $153 million and -$177 million.
Is there a light at the end of the tunnel for Paramount? The CEO commented on the full year 2022 financial results that, “Paramount Pictures had six films open at #1 in the U.S. box office and Paramount regained its position as the most-watched media family in linear television. Our content and platform strategy is working and, with even more exceptional content coming this year, we expect to return the company to earnings growth in 2024.”
Should investors be patient and wait for earnings growth one year from now? I do not think that makes much sense, despite the forward dividend yield of 4.25%. Financial performance is poor and growth is nowhere evident. I believe it is more reasonable now to avoid this value trap until it can prove its rocky past and high debt aren't holding it back anymore.
