Different people have different style of evaluating and doing research before investing in stock market. Technical analyst will try to capture the investor’s emotions on charts and will try to communicate with others about his findings. Fundamental analyst who makes decision on PE ratio whether the stock is cheap or costly would be sharing his view.

Before coming up on buy or sell decisions, it is important to understand the quality of business. You will find many stocks looking cheap in the market, but not necessary of great quality. If we do the homework of understanding the fundamentals or driving forces of the business and then look at the charts or look at PE ratios will give clear idea and understanding about chart pattern and whether the stock is trading at cheap or not.

It is not necessary that if PE ratios or chart are saying the price is cheap of any stock, is necessarily true. To explain this I will be using example of Bharti shipyard. Many analyst and brokerage houses have different views on this one.

Sushil finance in their research report dated 21st May 2011 has given a target of INR270. Their rationale behind it was that Q4 results were better then previous year. They also say that interest charges and depreciation has gone substantially up! But still believe that this business is worth INR270.

ICICIDirect in their research report dated 18th May 2011 on same stock advises to hold the stock with target price of INR 136.the rationale behind their advice is that they are not seeing any growth in revenue in future years as order book is sluggish.

P Liladher advised its clients in research report dated 18th May 2011 to accumulate Bharti Shipyard for the target price of INR153. The rationale behind their finding was that results were as expected. Debt in quarter has increased by 5 billion INR, revenues grew by 7.6%, operating margins stood steady and unexecuted order book is standing of 10 billion INR.

The highest target we got was INR270 and lowest target we got was INR136. After reading 3 different opinions of same company I feel something is fishy. So I tried to do my analysis and leave it on you to decide about it.

The very first thing I do is to find the quality of business through quantitative analysis and rate its quality. After running almost 30 separate metrics on 2009-10 annual reports and 2010 –11 available profit and loss statements, I came to conclusion that Bharti Shipyard VQR (Valueoperations quality rating) is ‘B1’.

Something to remember about quality and performance ratings…

Ratings are A1, A2, B1, B2 and C; every listed company is rated by Valueoperations based on a series of over 30 separate metrics, measured at both a point in time and over time. Most importantly, the Quality and Performance Rating is applied without any subjectivity. All companies are judged according to the metrics they generate. A1s have the lowest probability of a liquidation event. “Lowest probability” however doesn’t mean a liquidity event won’t occur. It just means far fewer A1s will have a liquidity event imposed on them compared to C rated company. A liquidity event includes a capital raising, debt default or renegotiation, administration, receivership etc. An A1 company could of course raise capital if it needs to fast track construction of a new factory. Sticking to A1s and avoiding C’s should, over time, produce better returns.

So we aggregated the performance of Bharti Shipyard for last 5 years available through online sources. Following are some highlights.

  • A total sale generated in last 5 years is, INR 4,863.34 Crore.
  • Net profits generated from business is, INR555.71 crore.
  • Net cash flow generated from operations is, INR 409.88 crore.
  • Net cash used in investing activity is, INR 2,492.78 crore.
  • Net cash they generated from finance is INR 2,328.87 crore.
  • Dividends paid to shareholders is, INR 43.84 crore.
  • An interest and depreciation expense for last 5 years is INR 524.31 crore.

If you ask me what I think about the above numbers, I would say that they are actively investing within their business, which is a very healthy thing for any business, but almost all of the money was sourced through borrowings.

If they had borrowed INR 1,000 crore less it would have great impact on their profit margins and return on its equity. I would have been tempted to get into this stock.

However as this business doesn’t come into A1 category for me I would have not bothered about calculating its intrinsic value. But if I still try to calculate it’s intrinsic value, Bharti Shipyard is trading at almost 50% discount to its expected 2012 results.

The discount is very tempting to invest in this business; however Bharti Shipyard lacks quality that we like to invest within. The other important thing to understand is that the discount is diminishing every quarter and every year without any upward movement within the price. So it means is intrinsic value is falling every year.