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Keppel Corporation Limited Has Low Valuations Now, But There’s 1 Key Risk To Note

Investors who are out looking for stocks with low valuations might want to meet the marine engineering and property development conglomerate Keppel Corporation Limited (SGX: BN4).

At the company’s current stock price of S$6.06, it has a price-to-earnings (PE) ratio of 7.2 and a price-to-book (PB) ratio of just 0.95. For perspective, the SPDR STI ETF (SGX: ES3) – an exchange-traded fund which tracks the fundamentals of Singapore’s stock market barometer, the Straits Times Index (SGX: ^STI) – is valued at 11.5 times earnings and 1.13 times its book value as of yesterday.

Keppel Corp’s valuation metrics are not just low when compared to the market – they are low when compared to their own history too. As Chart 1 below shows, the company’s PE and PB ratios are both near five-year lows.

Chart 1 - Keppel Corp's PE and PB ratios from 13 April 2011 to 13 April 2016 (2)
Source: S&P Global Market Intelligence

The company’s low valuations may help set the stage for a positive mean reversion to occur. A mean reversion is the simple idea that something that has moved away from the average will return to it over time. In investing, boom-bust cycles are a great example of mean reversion at work, as is the phenomenon of how below-average valuations can lead to above-average outcomes.

But, it’s vitally important to note that a stock need not be a bargain just because it currently has a low valuation. As investor Ric Dillon puts it:

“On the behavioural-finance side, one of many inefficiencies comes from people anchoring on the past. People assume something is cheap, say just because it hasn’t traded at such a low valuation for five or ten years. But that doesn’t matter, what matters is what will be.”

A closer look at certain aspects of Keppel Corp’s business reveals that there may be a cause for worry when it comes to “what will be.” You can see it in Chart 2, which plots changes in the conglomerate’s returns on equity and net-debt to equity ratio (where net-debt refers to total borrowings and capital leases minus cash and short-term investments) from 2010 to 2015:

Chart 2 - Keppel Corp's returns on equity (ROE) and net-debt to equity (NDE) ratios from 2010 to 2015
Source: S&P Global Market Intelligence

Over the past six years under study, Keppel Corp’s returns on equity have fallen in almost every year. In fact, its return on equity of 12% in 2015 is nearly half that of the 22% seen in 2010. To add insult to injury, Keppel Corp’s net-debt to equity ratio had also increased from a near-zero level to over 50% over the same period.

Theoretically, companies can increase their returns on equity by borrowing more money. But in the case of Keppel Corp, a rise in borrowings have been accompanied by a falling return on equity instead. Now, what’s important is this could be a sign of deterioration in the economics of Keppel Corp’s business.

Mean reversion applies to many areas in life, and it includes a company’s business results. In other words, there’s a chance that Keppel Corp’s falling return on equity seen from 2010 to 2015 is something temporary in nature.

But if that’s not the case – meaning to say that the economic characteristics of Keppel Corp’s business is on a long-term downward spiral or have been weakened almost permanently – then even the company’s valuations may not make it a bargain. That’s a key risk that current and prospective investors in Keppel Corp may want to consider.

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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 companies mentioned.