To the annoyance of some shareholders, Arch Coal (NYSE:ARCH) shares are down a considerable 41% in the last month. And that drop will have no doubt have some shareholders concerned that the 65% share price decline, over the last year, has turned them into bagholders. For those wondering, a bagholder is someone who keeps holding a losing stock indefinitely, without taking the time to consider its prospects carefully, going forward.
All else being equal, a share price drop should make a stock more attractive to potential investors. 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. So, on certain occasions, long term focussed investors try to take advantage of pessimistic expectations to buy shares at a better price. Perhaps the simplest way to get a read on investors' expectations of a business is to look at its Price to Earnings Ratio (PE Ratio). A high P/E implies that investors have high expectations of what a company can achieve compared to a company with a low P/E ratio.
How Does Arch Coal's P/E Ratio Compare To Its Peers?
We can tell from its P/E ratio of 2.26 that sentiment around Arch Coal isn't particularly high. The image below shows that Arch Coal has a lower P/E than the average (6.1) P/E for companies in the oil and gas industry.
Its relatively low P/E ratio indicates that Arch Coal shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with Arch Coal, it's quite possible it could surprise on the upside. 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
Probably the most important factor in determining what P/E a company trades on is the earnings growth. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. That means even if the current P/E is high, it will reduce over time if the share price stays flat. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Arch Coal saw earnings per share decrease by 9.3% last year. But over the longer term (3 years), earnings per share have increased by 121%.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. 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.
Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
How Does Arch Coal's Debt Impact Its P/E Ratio?
Arch Coal has net debt worth just 5.1% of its market capitalization. So it doesn't have as many options as it would with net cash, but its debt would not have much of an impact on its P/E ratio.
The Verdict On Arch Coal's P/E Ratio
Arch Coal trades on a P/E ratio of 2.3, which is below the US market average of 11.8. Since it only carries a modest debt load, it's likely the low expectations implied by the P/E ratio arise from the lack of recent earnings growth. What can be absolutely certain is that the market has become more pessimistic about Arch Coal over the last month, with the P/E ratio falling from 3.8 back then to 2.3 today. For those who prefer to invest with the flow of momentum, that might be a bad sign, but for deep value investors this stock might justify some research.
Investors should be looking to buy stocks that the market is wrong about. As value investor Benjamin Graham famously said, 'In the short run, the market is a voting machine but in the long run, it is a weighing machine. So this free visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
But note: Arch Coal 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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