When cheap is crap

In the stock market, a correction in the stock price augurs well for investors, especially when a stock trades at a low P/E, P/B or price-earnings-to-growth (PEG). While these three ratios prove to be effective in identifying fundamentally sound companies at throwaway prices, at times they lure investors to park their money in those companies that are trading at ultra-low valuations because of some serious issues, such as corporate-governance lapses, lower earnings quality, high debt or promoter pledging.

These valuation ratios do not capture all these qualitative parameters. Hence, naive investors tend to get attracted by these ratios rather than digging deep to know why the company is trading at low prices. This ends up in wrong decisions. An increasing number of retail investors in recent falling knives like DHFL, Manpasand Beverages, PC Jewellers, Reliance Communication and Kwality testify to the fact. All these stocks have proved to be serious wealth destroyers, even though they were available at very low valuations.

Even when it comes to fundamentally sound companies, it is not a good idea to rely only on lower ratios. Many times, the earnings of a company can be influenced by one-time extraordinary items, which in turn lead to very low or very high P/E or PEG ratios. An investor should carefully inspect the presence of any such item before taking a decision based on these ratios. For instance, Thomas Cook traded at a P/E of just 1.58 times in March 2019 owing to the presence of a large one-time gain. But its adjusted P/E stood at 155 times.

Value gurus like Benjamin Graham emphasised investing in a company trading at a low price-to-book ratio. However, this ratio holds little significance in today's world where companies have lots of intangibles, intellectual property and patents on their balance sheets, which are not reflected in their book values.

Besides, companies have many off-balance-sheet items or contingent liabilities such as debt guarantee of associates, tax cases and legal disputes, which are again not reflected in their book value. Although book value works well when it comes to evaluating banking and finance companies, it cannot be relied on for other businesses, given the many complexities involved.