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Beacon Equity Research

Market Commentary

Jeff Lawrence, CFA
[email protected]

vFinance ... Why a Low P/E Doesn’t Mean "Value"

I recently received a call from a friend who does not work in the financial markets, but is an avid recreational stock-picker. He enthusiastically recommended that I take a look at a company called vFinance, Inc. (OTCBB: VFIN). He indicated that the company was in the financial services sector and was trading at a ridiculously low P/E ratio of 5.

Never wanting to miss a potential opportunity, I immediately set out to find more information on the company. First, I checked the P/E ratio myself and discovered that the trailing P/E was, in fact, less than 5! I am not a proponent of using trailing P/E and always prefer to use a projected forward P/E, but I won’t go into that now.

Next, I viewed the company profile and scanned the news releases that had come out in the past few months about the company. This gave me a better handle on the key markets in which the company was involved and allowed me to estimate comparable P/Es based on its peer group. After this, I visited some of the popular small-cap message boards, where one poster commented on how the company was severely undervalued and at a normal financial services P/E ratio, the company should be trading at a level at least three times as high as where the stock price currently was. Another poster indicated that there is almost no risk since at such a low P/E ratio, there is very little downside. Overall, the sentiment seemed to be very high, which still didn’t explain the low P/E to me.

Finally, I decided to get into the numbers, which I believe usually tell the true story about a company. As I indicated earlier, I am not a proponent of using historical earnings data for anything other than a tool to aid in projecting future earnings. However, by ensuring that I understand the reasons that a company’s earnings have historically changed I will have a much better idea of what will impact them in the future.

I managed to get my hands on VFIN’s last three quarterly reports and began to comb through them. In the latest report (September 2004) there was nothing that particularly stood out, with the exception of the following excerpt: “During the current quarter, the Company's results were unfavorably impacted by a worsening market environment. Also during the current quarter, the Company's business was interrupted for several days as a result of Hurricane Frances which effected the operations of its South Florida headquarters.”

From this, I noted that the following quarter would probably be stronger since the impact of Hurricane Frances may not be as great. I also noted that the overall market may be worsening, which isn’t great news for the longer-term horizon. However, neither of these items explained to me why the company was trading at 1/3 of its peers multiples.

I then looked at the June 2004 report, which told me even less. However, when I went back even further to the March 2004 report, I hit the jackpot. In the management commentary section of the report, it indicated that during the quarter the company had entered into an agreement with a new clearing firm, and that the clearing firm had agreed to pay $1,500,000 that vFinance owed to another entity. This resulted in a one-time gain of this amount to vFinance. In addition to this, during the quarter the company recorded a $400,000 income tax benefit.

The impact of this is that although the company is trading at an unadjusted trailing P/E ratio of less than 5, the adjusted P/E ratio and the forward P/E ratios are much higher. Although I have not fully analyzed and valued the company, I suspect that it will fall much closer to its peers than at first glance.

The moral of the story is that at least three people (my friend, and the two message board posters), and probably many more, purchased this stock without actually digging into the numbers to understand what they were really buying. I believe this is a major mistake that many amateur stock-pickers make that could be easily corrected.