Unfortunately for some shareholders, the Codan (ASX:CDA) share price has dived 32% in the last thirty days. Looking at the bigger picture, the stock is up 76% in the last year.
Assuming nothing else has changed, a lower share price makes a stock more 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 long term investors have an opportunity when expectations of a company are too low. 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.
Does Codan Have A Relatively High Or Low P/E For Its Industry?
Codan's P/E is 18.22. You can see in the image below that the average P/E (19.4) for companies in the electronic industry is roughly the same as Codan's P/E.
Its P/E ratio suggests that Codan shareholders think that in the future it will perform about the same as other companies in its industry classification. If the company has better than average prospects, then the market might be underestimating it. Checking factors such as director buying and selling. could help you form your own view on if that will happen.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. When earnings grow, the 'E' increases, over time. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Most would be impressed by Codan earnings growth of 12% in the last year. And earnings per share have improved by 40% annually, over the last five years. This could arguably justify a relatively high P/E ratio.
Remember: P/E Ratios Don't Consider The Balance Sheet
The 'Price' in P/E reflects the market capitalization of the company. Thus, the metric does not reflect cash or debt held by the company. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.
So What Does Codan's Balance Sheet Tell Us?
Since Codan holds net cash of AU$51m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On Codan's P/E Ratio
Codan trades on a P/E ratio of 18.2, which is above its market average of 14.7. Its net cash position supports a higher P/E ratio, as does its solid recent earnings growth. Therefore it seems reasonable that the market would have relatively high expectations of the company What can be absolutely certain is that the market has become significantly less optimistic about Codan over the last month, with the P/E ratio falling from 26.6 back then to 18.2 today. For those who prefer to invest with the flow of momentum, that might be a bad sign, but for a contrarian, it may signal opportunity.
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. 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.
You might be able to find a better buy than Codan. 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 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.
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.