To the annoyance of some shareholders, Collins Foods (ASX:CKF) shares are down a considerable 30% in the last month. Zooming out, the recent drop wiped out a year's worth of gains, with the share price now back where it was a year ago.
Assuming nothing else has changed, a lower share price makes a stock more attractive to potential buyers. While the market sentiment towards a stock is very changeable, in the long run, the share price will tend to move in the same direction as earnings per share. The implication here is that long term investors have an opportunity when expectations of a company are too low. One way to gauge market expectations of a stock is to look at its Price to Earnings Ratio (PE Ratio). Investors have optimistic expectations of companies with higher P/E ratios, compared to companies with lower P/E ratios.
How Does Collins Foods's P/E Ratio Compare To Its Peers?
We can tell from its P/E ratio of 20.14 that sentiment around Collins Foods isn't particularly high. We can see in the image below that the average P/E (23.3) for companies in the hospitality industry is higher than Collins Foods's P/E.
This suggests that market participants think Collins Foods will underperform other companies in its industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
How Growth Rates Impact P/E Ratios
Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. When earnings grow, the 'E' increases, over time. That means unless the share price increases, the P/E will reduce in a few years. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Collins Foods shrunk earnings per share by 7.8% last year.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
The 'Price' in P/E reflects the market capitalization of the company. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).
Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.
Collins Foods's Balance Sheet
Collins Foods's net debt is 25% of its market cap. That's enough debt to impact the P/E ratio a little; so keep it in mind if you're comparing it to companies without debt.
The Bottom Line On Collins Foods's P/E Ratio
Collins Foods has a P/E of 20.1. That's higher than the average in its market, which is 15.9. With modest debt but no EPS growth in the last year, it's fair to say the P/E implies some optimism about future earnings, from the market. What can be absolutely certain is that the market has become significantly less optimistic about Collins Foods over the last month, with the P/E ratio falling from 28.8 back then to 20.1 today. For those who prefer to invest with the flow of momentum, that might be a bad sign, but for a contrarian, it may signal opportunity.
When the market is wrong about a stock, it gives savvy investors an opportunity. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
But note: Collins Foods may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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