As a rough rule of thumb, a company trading on a P/E ratio of 10 or under is considered to be cheap. There are often good reasons why the company's shares are cheap though – although the market doesn't always allow mispricing to stay around for very long.
In other words, if a company's P/E ratio drops and ends up under 10x, bargain hunters are usually waiting, which can see the share price rise, removing the bargain.
One reason why company's share prices can consistently remain under 10x is if the market considers the outlook (and therefore earnings) is negative.
Take two companies in the mining services sector, Monadelphous Group Limited (ASX: MND) and GR Engineering Services Ltd (ASX: GNG). Both companies currently sport P/E ratios under 10, 9.0x for Monadelphous, 9.8x for GR Engineering, and analyst consensus earnings forecasts suggest a P/E ratio of 10.2x for Monadelphous and 8.9x for GR Engineering.
That's despite both companies generating solid returns on equity, (22.6% for Monadelphous, 21.2% for GR Engineering) and solid net cash balances. Monadelphous reported $182.7 million of net cash at the end of December 2015, only slight down (0.9%) from 12 months prior to that. GR Engineering had $42.6 million in net cash – down from $50.4 million at the end of December 2014.
The concern investors appear to have about both companies is that earnings will fall. In the last half year, Monadelphous saw revenues sink 30% and net profit down 38%. GR Engineering, on the other hand, reported a 20% increase in revenues and a 34% increase in net profit for the half year. The company even raised its interim dividend by 11% to 5 cents, fully franked. No surprise then that the company's share price hasn't been as hard hit as Monadelphous'.
Where to next?
The outlook for both companies was different too. GR Engineering expects the second half to be 'consistent' with the first half, while Monadelphous says market conditions 'remain challenging', and is forecasting full-year revenue to be around 25% lower than in 2015. Margins are also under pressure, with a surplus of service providers and reduced work available.
Resource sector capital expenditure is not expected to hit bottom until late in 2017, suggesting Monadelphous, at least, faces a tough short-term period ahead. GR Engineering appears to be making a better fist of things, although it too has seen its margins compressed. The company's gross margin dropped from 18% to just 12% in the last half.
That suggests to me that despite their cheap prices, earnings are at risk of falling, perhaps less so at GR Engineering though, and investors could see cheaper prices ahead. In the meantime, Monadelphous's yield of 9.6% and GR Engineering's 10.2% yield might make up for some of the pain.
Almond pains
Another company that has been beaten up and spat out by the market is Select Harvests Limited (ASX: SHV). The almond producer's shares currently trade on a trailing P/E ratio of 5.6x, with a forecast of 8.5x. The share price has dropped nearly 60% from a high of $13.64 in August last year to trade around $4.82 currently. That's despite delivering $80 million in operating cash flow in the six months to December 2015 – for a company with a market cap of roughly $350 million. A rough calculation suggests shares are trading on just over 2x annualised operating cash flow – which is cheap by any measure. Select also boasts a whopping dividend yield of 11.5%, although it's unfranked.
But Select Harvests says the almond market is uncertain, with prices falling from record highs of US$4.70 a pound in August 2015 to US$2.60 in January this year – a three-year low. The Financial Times reports that buyers have disappeared and trading has ground to a halt – – one reason why Select is struggling to sell product. The company says it has sold just 16% of its 2016 crop compared to 30% last year.
Like the two mining services companies, Select Harvests' shares appear to have a cheap price for a very good reason. Earnings this year are likely to be materially lower than last year, and analyst forecasts appear far too optimistic.
Foolish takeaway
If you are comfortable seeing your shares sink and prepared to take a long-term approach, then now might a good time to dip your toe in, but investors will more than likely get a better opportunity to buy shares at cheaper pricesdown the track.
