Aries Agro (NSE:ARIES) shares have had a really impressive month, gaining 30%, after some slippage. But shareholders may not all be feeling jubilant, since the share price is still down 34% in the last year.
Assuming no other changes, a sharply higher share price makes a stock less attractive to potential buyers. In the long term, share prices tend to follow earnings per share, but in the short term prices bounce around in response to short term factors (which are not always obvious). The implication here is that deep value investors might steer clear when expectations of a company are too high. One way to gauge market expectations of a stock is to look at its Price to Earnings Ratio (PE Ratio). A high P/E ratio means that investors have a high expectation about future growth, while a low P/E ratio means they have low expectations about future growth.
How Does Aries Agro's P/E Ratio Compare To Its Peers?
Aries Agro's P/E of 8.18 indicates relatively low sentiment towards the stock. We can see in the image below that the average P/E (11.0) for companies in the chemicals industry is higher than Aries Agro's P/E.
Aries Agro's P/E tells us that market participants think it will not fare as well as its peers in the same industry. Since the market seems unimpressed with Aries Agro, it's quite possible it could surprise on the upside. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.
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. 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. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
Aries Agro shrunk earnings per share by 9.0% last year. But over the longer term (3 years), earnings per share have increased by 23%. And over the longer term (5 years) earnings per share have decreased 4.6% annually. So it would be surprising to see a high P/E.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
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. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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.
Aries Agro's Balance Sheet
Aries Agro has net debt worth a very significant 198% of its market capitalization. This level of debt justifies a relatively low P/E, so remain cognizant of the debt, if you're comparing it to other stocks.
The Verdict On Aries Agro's P/E Ratio
Aries Agro has a P/E of 8.2. That's below the average in the IN market, which is 13.6. When you consider that the company has significant debt, and didn't grow EPS last year, it isn't surprising that the market has muted expectations. What is very clear is that the market has become less pessimistic about Aries Agro over the last month, with the P/E ratio rising from 6.3 back then to 8.2 today. For those who like to invest in turnarounds, that might mean it's time to put the stock on a watchlist, or research it. But others might consider the opportunity to have passed.
Investors have an opportunity when market expectations about a stock are wrong. 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. Although we don't have analyst forecasts shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.
You might be able to find a better buy than Aries Agro. 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).
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If you spot an error that warrants correction, please contact the editor at email@example.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. Thank you for reading.