1 Thing You Shouldn’t Do When Bargain Hunting

I’d cut to the chase and give it to you straight – when looking for cheap shares to buy, the one thing you shouldn’t do is to depend solely on the superficial valuation numbers you see. Here’s why.

Offshore support services provider EMAS Offshore Ltd  (SGX: UQ4) looks to be a smashing bargain at its current price of S$0.21 as it’s valued at a mere 0.3 times its trailing earnings.

For some perspective on how outrageously cheap that looks, the SPDR STI ETF (SGX: ES3) – an exchange-traded fund which mimics the fundamentals of the market benchmark, the Straits Times Index (SGX: ^STI) – has a price-to-earnings (PE) ratio of around 12 at the moment. It’s worth noting too that the Straits Times Index is at the lower end of its own historical valuation ranges given that it had an average PE of 16.9 from 1973 to 2010.

So, here we are with a share that’s 40 times cheaper than the market. But, the picture changes significantly when we dig deeper.

Turns out, EMAS Offshore’s profit of US$199.5 million for the fiscal year ended 31 August 2015 (FY2015) had included US$193.0 million in “Other operating income” that’s largely related to the sale of vessels and negative goodwill that had arose from an acquisition.

(When a company make an acquisition at a price that’s less than the appraised value of the target, the acquirer gets to book a ‘profit.’)

In other words, a big chunk of EMAS Offshore’s profit over the last 12 months had come from non-recurring items. The following’s a very rough estimate, but if we were to strip the “Other operating income” from the company’s income statement, we’re going to be left with a profit of around US$7 million. With EMAS Offshore’s current market capitalisation of S$92 million, the company’s now actually worth around nine times its trailing adjusted earnings.

Currently, EMAS Offshore has a very weak balance sheet with a net debt to equity ratio of 104%. In addition to being in a very difficult business environment with the low price of oil, the company has also failed to produce any positive operating cash flow in each of FY2015 and FY2014. These traits add to the risks that an investor has to take with EMAS Offshore.

When we put the firm’s operating environment, balance sheet, and cash flow pictures together with its adjusted valuation number (which is only around 30% lower than the market’s), the risk profile for EMAS Offshore would be much higher as compared to if it were really trading at a PE of less than 1.

EMAS Offshore may or may not be a long-term stock market winner at this juncture – that’s not what I’m concerned with. Instead, the point here is to highlight how a seemingly cheap stock’s risk can change significantly if one goes on to dig beneath the surface. That’s why we shouldn’t depend on just superficial valuation metrics when bargain hunting.

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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 writer Chong Ser Jing doesn't own shares in any company mentioned.