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Despite Its High P/E Ratio, Is Arcos Dorados Holdings Inc. (NYSE:ARCO) Still Undervalued?

Simply Wall St

Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll apply a basic P/E ratio analysis to Arcos Dorados Holdings Inc.'s (NYSE:ARCO), to help you decide if the stock is worth further research. Looking at earnings over the last twelve months, Arcos Dorados Holdings has a P/E ratio of 26.66. That is equivalent to an earnings yield of about 3.8%.

See our latest analysis for Arcos Dorados Holdings

How Do You Calculate A P/E Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)

Or for Arcos Dorados Holdings:

P/E of 26.66 = $7.32 ÷ $0.27 (Based on the year to September 2019.)

Is A High P/E Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. That isn't a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.

How Does Arcos Dorados Holdings's P/E Ratio Compare To Its Peers?

The P/E ratio essentially measures market expectations of a company. The image below shows that Arcos Dorados Holdings has a higher P/E than the average (22.4) P/E for companies in the hospitality industry.

NYSE:ARCO Price Estimation Relative to Market, December 10th 2019

That means that the market expects Arcos Dorados Holdings will outperform other companies in its industry. Clearly the market expects growth, but it isn't guaranteed. So further research is always essential. I often monitor director buying and selling.

How Growth Rates Impact P/E Ratios

Companies that shrink earnings per share quickly will rapidly decrease the 'E' in the equation. That means unless the share price falls, the P/E will increase in a few years. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.

Arcos Dorados Holdings saw earnings per share decrease by 40% last year. And EPS is down 2.9% a year, over the last 3 years. This might lead to low expectations.

Don't Forget: The P/E Does Not Account For Debt or Bank Deposits

It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. So it won't reflect the advantage of cash, or disadvantage of debt. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.

While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.

How Does Arcos Dorados Holdings's Debt Impact Its P/E Ratio?

Arcos Dorados Holdings has net debt equal to 34% of its market cap. While it's worth keeping this in mind, it isn't a worry.

The Bottom Line On Arcos Dorados Holdings's P/E Ratio

Arcos Dorados Holdings has a P/E of 26.7. That's higher than the average in its market, which is 18.5. 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.

Investors should be looking to buy stocks that the market is wrong about. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. So this free report on the analyst consensus forecasts could help you make a master move on this stock.

You might be able to find a better buy than Arcos Dorados Holdings. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.