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Does Ashtead Group plc's (LON:AHT) P/E Ratio Signal A Buying Opportunity?

Simply Wall St

This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll show how you can use Ashtead Group plc's (LON:AHT) P/E ratio to inform your assessment of the investment opportunity. Ashtead Group has a price to earnings ratio of 13.84, based on the last twelve months. That is equivalent to an earnings yield of about 7.2%.

See our latest analysis for Ashtead Group

How Do I Calculate Ashtead Group's Price To Earnings Ratio?

The formula for P/E is:

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

Or for Ashtead Group:

P/E of 13.84 = £23.80 ÷ £1.72 (Based on the trailing twelve months to July 2019.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that investors are paying a higher price for each £1 of company earnings. 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.

Does Ashtead Group Have A Relatively High Or Low P/E For Its Industry?

We can get an indication of market expectations by looking at the P/E ratio. We can see in the image below that the average P/E (15.3) for companies in the trade distributors industry is higher than Ashtead Group's P/E.

LSE:AHT Price Estimation Relative to Market, November 3rd 2019
LSE:AHT Price Estimation Relative to Market, November 3rd 2019

This suggests that market participants think Ashtead Group 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. 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

P/E ratios primarily reflect market expectations around earnings growth rates. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. And in that case, the P/E ratio itself will drop rather quickly. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

Ashtead Group shrunk earnings per share by 17% over the last year. But over the longer term (5 years) earnings per share have increased by 29%.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

The 'Price' in P/E reflects the market capitalization of the company. So it won't reflect the advantage of cash, or disadvantage of debt. In theory, a company can lower its future P/E ratio by using cash or debt to invest in 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.

Is Debt Impacting Ashtead Group's P/E?

Ashtead Group has net debt equal to 39% of its market cap. While that's enough to warrant consideration, it doesn't really concern us.

The Verdict On Ashtead Group's P/E Ratio

Ashtead Group trades on a P/E ratio of 13.8, which is below the GB market average of 16.9. 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.

When the market is wrong about a stock, it gives savvy investors an opportunity. 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.

Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.

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.

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. Thank you for reading.