To the annoyance of some shareholders, DLSI (EPA:ALDLS) shares are down a considerable 46% in the last month. Indeed the recent decline has arguably caused some bitterness for shareholders who have held through the 42% drop over twelve months.
Assuming nothing else has changed, a lower share price makes a stock more attractive to potential buyers. 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 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 DLSI Have A Relatively High Or Low P/E For Its Industry?
We can tell from its P/E ratio of 3.83 that sentiment around DLSI isn't particularly high. The image below shows that DLSI has a lower P/E than the average (9.1) P/E for companies in the professional services industry.
DLSI's P/E tells us that market participants think it will not fare as well as its peers in the same 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
When earnings fall, the 'E' decreases, over time. That means unless the share price falls, the P/E will increase in a few years. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.
DLSI shrunk earnings per share by 19% over the last year. But over the longer term (5 years) earnings per share have increased by 5.6%. And EPS is down 1.8% a year, over the last 3 years. This could justify a low P/E.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. 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.
DLSI's Balance Sheet
DLSI has net debt worth 61% of its market capitalization. This is a reasonably significant level of debt -- all else being equal you'd expect a much lower P/E than if it had net cash.
The Bottom Line On DLSI's P/E Ratio
DLSI's P/E is 3.8 which is below average (13.5) in the FR market. 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. Given DLSI's P/E ratio has declined from 7.1 to 3.8 in the last month, we know for sure that the market is more worried about the business today, than it was back then. 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. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. Although we don't have analyst forecasts you might want to assess this data-rich visualization of earnings, revenue and cash flow.
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.
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.
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