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When a Cheap Share Isn’t Cheap

Ser Jing - When a Cheap Share Isn't Cheap (pic) In investing-parlance, it’s common to herald a share with low valuations as cheap. Low valuations can mean the share carrying different combinations of a low Price-Earnings (PE) ratio, a low Price-to-Book (PB) ratio or a low Price-to-Sales (PS) ratio. Generally speaking, low valuations are often seen as a sign of a bargain for investors.

After all, the basic precinct of the discipline of value investing, which originated from Benjamin Graham and then made famous by the stunning success of American billionaire investor Warren Buffett, was to buy shares at low valuations.

But, there’s often a point that’s missed by investors looking at ratios superficially. Investors looking for value aren’t just looking for shares with low valuations. They want shares with valuations that are low in relation to underlying fundamentals.

In other words, Company A selling for a PE of 8 while showing declining earnings-per-share (EPS) might turn out to be more expensive than Company B trading at a PE of 20 while growing EPS at 30% per year.

Let’s take a look at how this plays out with the following shares.

3 Jan 2011

Company Price TTM EPS* TTM PE*
Pacific Andes Resources (SGX: P11) $0.37 4.69 cents 7.9
Raffles Medical Group (SGX: R01) $2.42 8.04 cents 30.1
*TTM = Trailing 12 months

Looking at valuations alone, it would seem on first glance that Pac Andes, a company involved with the development, marketing and distribution of fish and fish products, is the better bet. After all, it carried a lower PE ratio than healthcare provider Raffles Medical Group.

Let’s see how that turned out though.

From 1 Jan 2011 to 5 July 2013, the Straits Times Index (SGX: ^STI) declined by 2% to 3,170. Meanwhile, RMG appreciated by 30% to $3.15, soundly beating the market. Unfortunately, the same can’t be said of Pac Andes, which has declined by 65% to $0.128, losing to the market by a wide margin.

Pac Andes had the lower valuation by far, so what gives?

Turns out, Pac Andes’ TTM EPS had fallen by 53% to 2.21 cents by 5 July 2013. The fall in EPS was partly due to numerous rights issues, which expanded the share count of the company from 2.81b to 4.79b shares, and partly due to a decline in TTM net income from S$131m to S$106m.

The company’s largely devoid of pricing power in its main business of selling fish, fishmeal and fish oil and are at the mercy of Mother Nature out at sea, depending on her to deliver greater catch volume of fish.

Besides, the company carried a debt-laden balance sheet with S$43m in cash and S$1.0b in debt back on 1 Jan 2011, leaving it extremely vulnerable to adverse changes in its business environment. Other measures of profitability for the company, such as its Return on Equity, also showed consecutive yearly declines for a few years prior to 1 Jan 2011. When put together, such business fundamentals make it hard to see sustained growth in earnings.

And, when earnings can’t grow, a ‘cheap’ share with a low valuation is no longer cheap.

On the other hand, RMG’s TTM EPS grew by 34% to 10.8 cents. The company’s riding on the wave of ageing populations in Asia, meeting demands for better quality healthcare and attracting more patients to their hospitals and medical centres because of excellent service and reputation.

With a history of solid execution behind its back (given the company’s growth in revenue, earnings and cash flow while having a solid balance sheet carrying more cash than debt), it seemed to have a clearer path in earnings growth when compared to Pac Andes.

Foolish Bottom Line

Valuation matters in investing. But, misleading conclusions can sometimes occur due to a superficial analysis of financial ratios, such as how investors might think a company’s shares are cheap just because it has a low PE multiple.

Ultimately, a cheap share might well turn out to be an expensive mistake when an investors drills beyond those ratios.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.