In Part1, we hv covered PE ratio, RSI, and Volume per hour of trades. In Part2, we will rely on those knowledge and enhance the reading of the market. To recap, if you like, you can think of PE ratio as repayment period, an ROI or a loan tenure where by a longer term may not be good. Depending on the industry, accptable PE ratio sits between 8 to 12. Hence the repayment should be optimum base on the business model against the Industry. In short IF PE is 10, you can think of it as 10 yrs to complete repayment or 10 yrs period after which to enjoy the ROI. True to the meaning, however PE does not and cannot factor in loan for expansion as compared to increasing liquidity of the share through means of corporate exercise. 

In this sense, Current Share Price to Earning Per Share (PE) ratio is the current earnings period taken to repay at current share price. First thing you would notice is, no reference to debt and the closest factor to debt is the possible interest expense (debt interest) before deriving the earnings/profit for the period. It is therefore for that reason debt gearing in all possible ratio (bond/equity, debt/earning, debt/capital. borrowing/revenue, interest expense/financial income....) is needed to ascertain further standing.  All the ratio gives you is an immediate current standing eg all the ratio must be below 1, all the ratio must be as low as possible to be considered healthy position. This is true for BAU (Business As Usual) operation however for expansion situation, this is acceptable BUT MUST correspond to PE in the way whereby IF the gearing is very high (1 or above), and the PE is very low as one of the criteria because a low PE could mean either your EPS is high or the price of your share is undervalued.

EPS is high is easy to derive as a simple relative comparison to previous other quarters will tell while a price of shares being low MUST correspond to a relative position. If that relative position is established, then the low price can be considered as undervalued. For further affirmation many use PB (Price to Book or Market to Book ratio) and PS (Price to Sales ratio)  to ascertain the appropriate value. Starting with PB, the lower the value (relative base on industry acceptance) the more undervalued it perceived to be unless bankruptcy is in the horizon for which we have already covered to ascertain the debt gearing. (Note bankruptcy can be reported or happen within the following quarter despite all the due dilligence done on previous quarter) Similarly PS or Market to Sales has the similar mechanism to indicate undervaluation in the same manner.

In the above, it is good to note that some sector/industry, valuation is done frequently and valuation can be ascertain easily. While all efforts to ensure no bankruptcy is in the horizon, (chances are unlikely if you hv done all the FA to minimize the possibility and the managment is a responsible one) and a valuation is derived. Sometimes we wonder why a counter is undervalued but the share price refuse to move forward, this maybe one of the reason. In this case check the gearing always!!

On the other hand, if the debt ratio is glaringly high, in the 0.7 and above band, the share price will surely reflect that. This risk are normally due to large borrowings for expansion that they could not recuperate due to various reason. In many cases, these companies stage a rebound by selling non core asset to get back into the black again and re-consolidate their asset and focus while some also buy into new business to mitigate their risk. In the course of their endeavour, I have seen many turnaround companies however not without much convincing by the management to their shareholders and potential shareholder.

One of the areas of convincing by management to buy the trust of existing shareholder or potential shareholder is how they maintain their "Cash Flow".

Moving ahead on this, whether a turnaround or a performing company, one key area is definitely the cash flow. Here we are looking at postive or negative cash flow and free cash flow. I hv taken the definition of "Cash Flow" from Business Dictionary and Investopedia which I felt best describe what I was thinking.

Positive Cash Flow - Normal situation where the cash inflows during a period are higher than the cash outflows during the same period. Positive cash flow does not necessarily means profit, and is usually due to a careful management of cash inflows and expenditure. Persistent and large positive cash flows may indicate the firm is not keeping enough stocks of raw materials or finished products, and might be losing sales due to shortages. (Source - Businessdictionary)

Negative Cash Flow - Situation where the cash outflows during a period are higher than the cash inflows during the same period. Negative cash flow does not necessarily means loss, and may be due only to a mismatch of expenditure and income. Chronic mismatch, however, may indicate ineffective credit management, leakage of funds through fraud, or actual loss. Temporary mismatch is covered usually by arranging an overdraft facility. (Source - Businessdictionary)

Free cash flow (FCF) is a measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it's tough to develop new products, make acquisitions, pay dividends and reduce debt. FCF is calculated as: EBIT(1-Tax Rate) + Depreciation & Amortization (Source - Investopedia)

The "Cash Flow" is one area which Investors will use to determine whether the management of the company they are investing in is prudent with good vision, are  focus & responsible and their ability to grow their business taking on large/larger expansion or whether the company's endeavour to stage a turnaround and rebuild their financial stature will likely succeed.

So in short, when we look at an undervalued stock with seemingly good fundamentals, it is essential to also look at their management ability and cash flow to sustain growth. Hence the next time when someone is calling a buy on an undervalued stock, do a due dilligence on gearing, expenditure and expansion plan against the management consistency to deliver. After all, business and sales growth are the key aspect of financial reporting.