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How Does Sonic Automotive's (NYSE:SAH) P/E Compare To Its Industry, After The Share Price Drop?

Simply Wall St

Unfortunately for some shareholders, the Sonic Automotive (NYSE:SAH) share price has dived 43% in the last thirty days. Looking back over the last year, the stock has been a solid performer, with a gain of 31%.

All else being equal, a share price drop should make a stock more 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). 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.

Check out our latest analysis for Sonic Automotive

How Does Sonic Automotive's P/E Ratio Compare To Its Peers?

Sonic Automotive's P/E of 5.42 indicates relatively low sentiment towards the stock. If you look at the image below, you can see Sonic Automotive has a lower P/E than the average (10.3) in the specialty retail industry classification.

NYSE:SAH Price Estimation Relative to Market, March 15th 2020

Its relatively low P/E ratio indicates that Sonic Automotive shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with Sonic Automotive, 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

Probably the most important factor in determining what P/E a company trades on is the earnings growth. When earnings grow, the 'E' increases, over time. That means even if the current P/E is high, it will reduce over time if the share price stays flat. Then, a lower P/E should attract more buyers, pushing the share price up.

Sonic Automotive's 174% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive. And earnings per share have improved by 18% annually, over the last three years. So we'd absolutely expect it to have a relatively high P/E ratio.

Don't Forget: The P/E Does Not Account For Debt or Bank Deposits

The 'Price' in P/E reflects the market capitalization of the company. 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).

Sonic Automotive's Balance Sheet

Sonic Automotive's net debt is considerable, at 286% of its market cap. This is a relatively high level of debt, so the stock probably deserves a relatively low P/E ratio. Keep that in mind when comparing it to other companies.

The Verdict On Sonic Automotive's P/E Ratio

Sonic Automotive trades on a P/E ratio of 5.4, which is below the US market average of 14.0. The company has a meaningful amount of debt on the balance sheet, but that should not eclipse the solid earnings growth. If the company can continue to grow earnings, then the current P/E may be unjustifiably low. What can be absolutely certain is that the market has become more pessimistic about Sonic Automotive over the last month, with the P/E ratio falling from 9.5 back then to 5.4 today. 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.

When the market is wrong about a stock, it gives savvy investors an opportunity. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free report on the analyst consensus forecasts could help you make a master move on this stock.

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 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.

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.