Every now and again, you come across a company trading at a cheap valuation that makes you scratch your head. Sometimes these cheap valuations can present an excellent opportunity to get in on a stock trading at bargain-bin prices. Other times these cheap valuations could signify that investors don't expect growth to continue.
It's only after diving into the numbers that you can get a good feel if it's one or the other.
One company with a dirt-cheap valuation that presents a great opportunity is B. Riley Financial (RILY 0.84%). This financial services firm focused on addressing the needs of small-cap companies trades at a price-to-earnings ratio (P/E) of just four, drastically lower than its five-year average P/E ratio of 28.5.
That begs the question: Why is Wall Street discounting this stock so much?
Image source: Getty Images.
Rapid earnings growth has shrunk its P/E ratio
B. Riley Financial provides a variety of financial services through various subsidiaries, which include things like investment banking, wealth management and brokerage, and liquidation and debt restructuring. The company has served small- and mid-cap companies for over 25 years now.
One reason B. Riley is trading so cheaply is its rapid growth on the bottom line that the stock price has not adjusted to. Through nine months this year, the firm's diluted earnings per share (EPS) checks in at $13.07, up significantly from its $1.14 diluted EPS posted through nine months last year. Since EPS is the denominator when calculating the P/E ratio, the rapid rise in EPS has caused the P/E ratio to shrink despite the stock price being up 107% since the start of 2021.
This year has been stellar for B. Riley's earnings, with the firm's capital markets segment leading the way. This segment, which includes investment banking activity and trading income, posted an income of $559 million through nine months this year. This represents a growth of 743% from last year. However, this segment makes up nearly 90% of the firm's total income in 2021.
B. Riley's outperformance this year can be attributed to robust investment banking activity. As a result, investors may be wary of investing in the company if they don't believe it can keep up such growth. Seeing its capital market segment generate 90% of its income is concerning. However, the financial services firm has positioned itself well by putting its cash to work to diversify its revenue sources.
B. Riley's goal is to weather any economic conditions
The way I look at it, robust investment banking activity has helped B. Riley significantly raise its cash balance to $378 million, up from $104 million at the end of last year. It has also seen its investments and other securities increase to $1.3 billion, up from $777 million at the end of last year. B. Riley has worked hard putting this cash to work by acquiring wealth management companies like National Holdings and 272 Capital.
The firm's purchase of these two companies illustrates its effort to diversify its revenue sources. Adding to its wealth management segment is a positive for B. Riley because it helps provide the firm with a steady revenue stream no matter the market conditions. Firms generally earn fees on the total assets under management (AUM) they handle for affluent clients. Wealth management can be an attractive revenue stream for investment banks because it is recurring and easier to predict.
The purchase of National Holdings gives B. Riley a larger footprint in wealth management. Before the acquisition, B. Riley Wealth Management had over 170 registered representatives and $10 billion in client assets. National Holding gave it a big boost, adding 733 registered representatives and nearly $19 billion in client assets.
So far this year, B. Riley's wealth management segment has brought in top-line revenue of $277 million, up 433% from last year. However, the segment has seen sales and administrative expenses increase nearly as much, which is why it isn't a bigger piece of its net income -- yet. Expenses for the segment increased primarily due to the National General purchase, which has cost it $203.3 million.
As B. Riley continues to integrate this purchase, margins should improve. While wealth management generated nearly $17 million in earnings before interest, taxes, depreciation, and amortization (EBITDA) this year, co-CEO and founder Bryant Riley said he believes this can be a $50 million to $60 million business within a year.
Insiders can't stop buying shares
Wall Street is overlooking B. Riley Financial because of its outperformance when it comes to investment banking. Perhaps investors don't believe the firm can continue to perform at such a high level. While investment banking may not see the same growth, the firm's moves to diversify its revenue streams to make its business more robust can't be ignored.
Another positive for the business is that management has skin in the game, with 40% of its stock held by insiders at the company. High levels of insider ownership are positive for investors because management is motivated to make it succeed. With focused management leading the way, B. Riley looks like a stellar value stock poised for long-term growth.
