Cango (NYSE:CANG) shareholders are no doubt pleased to see that the share price has had a great month, posting a 50% gain, recovering from prior weakness. But shareholders may not all be feeling jubilant, since the share price is still down 24% in the last year.
All else being equal, a sharp share price increase should make a stock less attractive to potential investors. 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. 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 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.
Does Cango Have A Relatively High Or Low P/E For Its Industry?
Cango's P/E of 21.55 indicates relatively low sentiment towards the stock. We can see in the image below that the average P/E (28.0) for companies in the online retail industry is higher than Cango's P/E.
This suggests that market participants think Cango will underperform other companies in its industry. Many investors like to buy stocks when the market is pessimistic about their prospects. 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
Earnings growth rates have a big influence on P/E ratios. Earnings growth means that in the future the 'E' will be higher. That means even if the current P/E is high, it will reduce over time if the share price stays flat. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
It's great to see that Cango grew EPS by 11% in the last year. And earnings per share have improved by 17% annually, over the last five years. With that performance, you might expect an above average P/E ratio.
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. That means it doesn't take debt or cash into account. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
How Does Cango's Debt Impact Its P/E Ratio?
The extra options and safety that comes with Cango's CN¥189m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Verdict On Cango's P/E Ratio
Cango's P/E is 21.5 which is above average (18.1) in its market. With cash in the bank the company has plenty of growth options -- and it is already on the right track. So it is not surprising the market is probably extrapolating recent growth well into the future, reflected in the relatively high P/E ratio. What is very clear is that the market has become significantly more optimistic about Cango over the last month, with the P/E ratio rising from 14.4 back then to 21.5 today. For those who prefer to invest with the flow of momentum, that might mean it's time to put the stock on a watchlist, or research it. But the contrarian may see it as a missed opportunity.
Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
You might be able to find a better buy than Cango. 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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